Washington Recaptured

WASHINGTON, DC – Two hundred years ago, Washington DC was captured by the British – who then proceeded to set fire to official buildings, including the White House, Treasury Department, and Congress. Today, it is a domestic interest group – very large banks – that has captured Washington. The costs are likely to be far higher than they were in 1814.

America’s largest bank holding companies receive an implicit government subsidy, because they are perceived to be “too big to fail.” The authorities will not allow the biggest banks to default on their debts, through bankruptcy or in any other fashion, owing to the need to prevent the financial system from collapsing. This doctrine became starkly apparent in late 2008 and early 2009; it remains in force today.

This effective exemption from the risk of bankruptcy means that anyone who lends to the largest half-dozen banks receives a government guarantee – free insurance against the risk of a catastrophe. This allows these banks to obtain more debt financing on better terms (from their perspective). In particular, their executives operate highly opaque firms, with risks effectively masked from outsiders and very little in the way of loss-absorbing shareholder equity. Simply put, without their government backstop, these murky empires could not exist.

Democratic Senator Sherrod Brown of Ohio and Republican Senator David Vitter of Louisiana, along with some important colleagues, have long sought to phase out this implicit subsidy. And independent analysts, such as Anat Admati of Stanford University, have explained all of the relevant details of how – and why – this should be done. Those details – for example, in Admati’s recent testimony to the Senate subcommittee chaired by Brown – are not in doubt. Thanks to Admati and her colleagues, we have a clear rendering of them in straightforward, non-technical language.