Ending Bailouts is Simple, but it Isn't Easy

30 days have passed, so I can post the full Wall Street Journal Oped with Amit Seru. Previous post with commentary and link to the underlying paper.

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There was a financial crisis in 2008. The U.S. government responded with bailouts. But if people know they will be bailed out in the next crisis, they take too much risk. Recognizing this danger, the government vastly expanded financial regulation under the Dodd-Frank Act of 2010. Other countries followed similar paths. Never again, they promised.

It just happened again.

When the pandemic hit in March 2020, many institutions wanted to sell Treasurys to raise cash. Treasury trading funnels through a few large banks. Up against ill-conceived liquidity and capital rules, the banks couldn’t handle the volume of trading, despite large profit opportunities. Prices fell, interest rates rose, spreads rose, and time to sell securities rose. The Federal Reserve stepped in, lending dealers money to buy Treasurys, buying the Treasurys from the dealers a few days later, and thereby propping up Treasury prices. The Fed continued to buy huge amounts of Treasury securities, eventually monetizing some $3 trillion of the $5 trillion new issues.

Money-market funds started having trouble selling assets to meet redemptions, and a run developed. The Fed stepped in again, lending to financial institutions to buy securities from money-market funds at higher prices.

Money-market funds are simple. Stopping money-market runs is simple. After a run in 2008, Dodd-Frank reforms were supposed to fix money-market funds. The reforms failed.

Corporate bond prices fell. The Fed swiftly announced corporate debt purchases, widely interpreted as a “whatever it takes” commitment that bond prices wouldn’t fall. Bond investors were bailed out of even mark-to-market losses.

Over the summer of 2020, the Fed, with the Treasury, bought newly issued debt directly from state and local governments in return for newly created money. The Paycheck Protection and Main Street Lending programs made forgivable loans to businesses and nonprofits. Other businesses got “employee retention” tax credits. Airlines were bailed out. Individuals received “stimulus” checks, mortgage and student loan forbearance, generous and extended unemployment benefits.

To some extent these transfers are also financial bailouts, as banks otherwise might not have been paid. But much of the point was to bail out indebted people and businesses, no longer only financial institutions whose failure threatens the flow of credit.

How much of this bailout was necessary isn’t our point. If it was necessary, as some surely was, the question is why the financial system was still so fragile that it needed another bailout. And in its wake moral hazard has unapologetically expanded. If you saved and bought a house with cash, if you saved and went to a cheaper college rather than taking out a big student loan, if you repaid loans promptly, if you kept some money around to buy on the dip, you lost. The lesson: Borrow. Buy risky debt.

Silicon Valley Bank and a few others suffered runs in early 2023. SVB took large uninsured deposits and invested them in long-term Treasury securities. No subprime mortgages, no collateralized loan obligations, no toxic derivatives, no special-purpose vehicles. SVB’s only risk was that higher interest rates would reduce the market value of its assets. When that happened, depositors ran. The army of regulators missed this simplest interest-rate risk. The Federal Deposit Insurance Corp. quickly guaranteed all deposits, of any size. Markets now expect that guarantee.

In March 2023, Credit Suisse was teetering. Its troubles were clearly isolated, with no “contagion” to worry about. Finally, here was a chance to use the big-bank reforms. Instead, the Swiss government orchestrated a weekend sale to UBS with an infusion of government money.

Our basic financial regulatory architecture allows a fragile and highly leveraged financial system but counts on regulators and complex rules to spot and contain risk. That basic architecture has suffered an institutional failure. And nobody has the decency to apologize, to investigate, to talk about constraining incentives, or even to promise “never again.” The institutions pat themselves on the back for saving the world. They want to expand the complex rule book with the “Basel 3 endgame” having nothing to do with recent failures, regulate a fanciful “climate risk to the financial system,” and bail out even more next time.

But the government’s ability to borrow or print money without inflation is finite, as we have recently seen. When the next crisis comes, the U.S. may simply be unable to bail out an even more fragile financial system.

The solution is straightforward. Risky bank investments must be financed by equity and long-term debt, as they are in the private credit market. Deposits must be funneled narrowly to reserves or short-term Treasurys. Then banks can’t fail or suffer runs. All of this can be done without government regulation to assess asset risk. We’ve understood this system for a century. The standard objections have been answered. The Fed could simply stop blocking run-proof institutions from emerging, as it did with its recent denial of the Narrow Bank’s request for a master account.

Dodd-Frank’s promise to end bailouts has failed. Inflation shows us that the government is near its limit to borrow or print money to fund bailouts. Fortunately, plans for a bailout-free financial system are sitting on the shelf. They need only the will to overcome the powerful interests that benefit from the current system.

Mr. Cochrane is a senior fellow at the Hoover Institution and an adjunct scholar at the Cato Institute. Mr. Seru is a senior fellow at the Hoover Institution and a professor of finance at Stanford’s Graduate School of Business. This essay is based on an article in the Journal of Law, Economics and Policy.