Double Whammy: Implicit Subsidies and the Great Financial Crisis

By Edward J. Kane, Professor of Finance, Boston College. Originally published at the Institute for New Economic Thinking website

A financial industry safety net enriches bankers and their shareholders — at our expense

Double whammy has two meanings.  One derives directly from “wham,” as in “wham-bam,” which is a way of approximating the sounds made by a solid one-two punch.  The second meaning comes from its use in the comic strip L’il Abner, where it meant a devastating curse that a hag named Nightmare Alice would cast on other characters from time to time.  Both meanings are relevant here.

The word subsidy covers any kind of direct or indirect payment, concession, or privilege granted by a government to private firms, households, or lesser governmental units.  A word that carries so many meanings calls out for a modifier.  An implicit subsidy is one that is hard to document because it is transmitted in kind or through favorable pricing and tax breaks rather than in the coin of the realm.  This paper concerns itself with the joint impact of implicit subsidies that are built into the US housing-finance system and financial safety net.  These subsidies are implicit because they are channeled through the regulatory, supervisory, and tax systems in hard-to-observe ways.  In the last two economic booms, their stealthiness has allowed these subsidies to build up so much malignant force that, when the extent of their political support was tested by a creditor run, the losses their stealthiness concealed pushed the nation’s financial system into an open crisis.

What an economist calls a crisis occurs when bad luck impacts a large industry whose managers have made its member institutions vulnerable to this amount and type of misfortune.  In one way or another, most banking crises are triggered by sudden falls in the price of key assets.  The twin subsidies featured in this paper encourage banks to make underpriced loans to housing-related sectors of the economy, particularly those that make or market residential housing or influence its affordability.  The ostensible public purposes of subsidies to housing are to improve fairness in society by encouraging home ownership and assuring healthful neighborhoods and adequate housing for low-income households (see Hock-Smit and Diamond, 2003).  Routing these subsidies through mortgage lenders suggests that a deeper purpose may be to subsidize realtors, builders, landlords, and mortgage lenders.  A major part of the safety-net subsidy is the quid US bankers receive for pricing mortgage loans favorably.  It consists of regulatory and supervisory indulgences that neglect the implicit loss exposures that subsidized mortgages and innovative instruments pass onto the safety net by the highly leveraged way these positions are financed.

Because both subsidies are implicit, they currently leave no paper trail.  Neither subsidy is explicitly accounted for in bank, borrower, or government financial statements.  Authorities could (if they wanted) track the effect of these subsidies in reducing the default premia and liquidity premia imbedded in the interest rates offered to mortgage borrowers by developing a way to approximate the unobservable interest rate that different types of borrowers would have had to pay in the absence of the subsidy.  Today, an official value for the consolidated housing-finance subsidy is not even tracked loosely, while the value of countervailing supervisory concessions that regulators and supervisors transmit to mortgage lenders through the safety net is not booked anywhere either.

Modeling the Sequence of Events Observed in a Subsidy-Induced Crisis

My narrative models of crisis generation locate efforts to preserve and extend rent-seeking opportunities for different-sized banks at the center of the process.  I contend that successful efforts to secure these subsidies owe a large debt to the supervisory and justice systems’ overbearing tolerance for self-serving financial-industry bullsh*t.[1] In the press and in history books, policymakers and industry-captured economists and accountants consistently misframe regulatory and supervisory incentive problems and the strength of potential justice-system remedies. In the Great Financial Crisis, the most important misframing was to deliberately misrepresent the ways that tail risks and the costs, benefits, and distribution of government tail-risk protections move through megabank balance sheets. Another was to misrepresent the purpose and productivity of innovations that cleverly circumvent and eventually unmask the futility of ill-conceived forms of regulation and supervision by generating de facto losses and transmitting these losses from bank to bank and country to country.[2]

Is Anybody Watching the Back Door?

Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time.  In this game, regulatees tend to make more moves than regulators do.  Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.

This is because the essence of banking is deal making.  Nowadays, banking crises occur when managers pursued concentrated tail risks that made their institutions increasingly vulnerable, but kept generating substantial and long-lasting safety-net subsidies until things finally went south.

Such subsidies can be long-lasting because the regulatory cultures of almost every country in the world today embrace —in one form or another— three strategic elements:

  • Politically-Directed Subsidies to Selected Borrowers (particularly to would-be homeowners):  The policy framework either explicitly requires—or implicitly rewards—institutions for making credit available to selected classes of borrowers at a subsidized interest rate;
  • Subsidies to Bank Risk-Taking: The policy framework commits government officials to offer on subsidized terms explicit and/or implicit (i.e., conjectural) guarantees of repayment to banks’ depositors and other kinds of counterparties engaging in complex forms of bank deal making;
  • Defective Monitoring and Control of the Subsidies: The contracting and accounting frameworks used by banks and government officials fail to make anyone directly accountable for reporting or controlling the size of these subsidies in a conscientious or timely fashion.

Taken together, the first two elements of the subsidization strategy invite commercial and investment banks to use the safety net to extract wealth surreptitiously from taxpayers.  To keep subsidy-generating leverage high, the bulk of the subsidies banks receive are promptly paid out to top managers and to shareholders in the form of dividends and share repurchases.  The rest is shifted forward and backward: mostly to large creditors and politically favored borrowers.  Favored borrowers are primarily blocs of voters (such as would-be homeowners) regularly courted by candidates for political office and traditional sources of outsized campaign support (such as bankers, builders, and realtors).  Ferguson, Jorgensen, and Chen (2017) define a comprehensive concept of “political money” that captures a number of indirect and subtle ways that bankers (especially) put money into a politician’s pocket or election campaign.  The directways include director’s and speaking fees, book contracts, jobs for family members, and stock tips.  Indirectchannels comprise laundering donations through law firms, charitable foundations, think tanks, and public-relations firms.

The third piece of the framework minimizes regulators’ exposure to blame when things go wrong. Gaps in the reporting system make it all but impossible for outsiders –particularly the press— to hold supervisors culpable for violating their ethical duties. These gaps prevent outsiders from understanding —let alone monitoring— the true costs and risks generated by the first two strategies.  Few politicians and regulators want to subject the intersectoral flow of net regulatory benefits to informed and timely debate.  This weakness in accountability exists because the press is often content with regurgitating the content of agency press releases and accounting systems do not report the value of regulatory benefits as a separate item for banks and other parties that receive them.

In modern accounting systems, the capitalized value of regulatory subsidies is treated instead as an intangible source of value that, if booked at all (as it usually is in acquisitions), is not differentiated from other elements of what is called an acquired bank’s “franchise value.” Of course, some of the subsidy is offset by tangible losses that politically influenced loans eventually force onto bank balance sheets and income statements. But in principle, a tangible reserve for expected losses ought to be set up (and is scheduled to be under FASB’s new loss-reserve standards) as part of the process of making either a subsidized or risky loan.

Although officials resist the idea, creating an enforceable obligation for regulators to estimate the ebb and flow of the dual subsidies in transparent and reproducible ways would be a useful first step in getting them under control.  This would make it easier for external watchdog organizations in the private sector to force authorities to explain whether and how these subsidies benefit taxpayers.

Why Does It Matter Whether the Subsidies Are or Are Not Booked Explicitly?

What the press characterizes as a “financial crisis” I would describe more colorfully as a game of chicken between supervisors and central banks on the one hand and formally uninsured institutions and creditors on the other.  At root, it is a messy scramble for help.  A powerful horde of loss-making institutions keeps it going until, using political force, they manage to compel the rest of society to cover the bills they owe for making bad loans and investments.  In US mortgage markets, longstanding systems for subsidizing poorly underwritten loans to builders and overleveraged households assign potential losses initially to the lending institutions, but these firms cover these losses with safety-net guarantees that pass their worst loss exposures onto national safety nets.

Booking loans at par when they are made to iffy borrowers on subsidized terms implies a projected time path of subsequent cash flows from these mortgages that understates the probable rate of future defaults and overstates the liquidity that these instruments transmit to mortgage lenders.  These false projections open up a gap between the book value and market value of highly subsidized mortgages.  The adverse effects of this gap emerge slowly as a series of ex postaccounting losses at lending banks, but only if the banks that originate the loans continue to hold them.

To see how this works, let’s assume that (if not for the housing-finance subsidy) the default and liquidity premia in a loan portfolio accruing 6 percent actually called for a market interest rate of 7 percent.  Booking these loans at par overstates their likely returns and, on average, the passage of time is bound to reveal this.

Savvy bankers should understand this and devise ways of shedding these loss exposures.  This is where securitizations come in.

How Securitizations Undermine Capital-Requirement Subsidy Control

The seeds of crisis are sown in good times.  Being allowed to under-reserve for write-downs that can be expected to occur over the life of long-term loans intensifies safety-net subsidies, and does so all the more if securitization lends a hand.  Securitization offered mortgage lenders a loophole opportunity to circumvent virtually all of the regulatory burden associated with the already-low capital requirements that the politics of the housing subsidy settles on housing-related assets.

When housing prices are booming, securitizing pools of loans rather than keeping them on balance sheet allows the lender to liquefy its share of both subsidies immediately and pass the funds through to its major stakeholders.  But the overleveraging and overvaluing of the lender’s portfolio of mortgage loans that securitization encourages cynically moves the entry points for future crisis into formally unguaranteed part of the banking system.

The process of using corporate subsidies to securitize subsidized mortgages may be visualized as setting loose the equivalent of a colony of termites to feed slowly on the asset and net-worth accounts posted on the conventional balance sheets of whoever books these loans at par.  Over time, the net worth of more and more mortgage holders hollows out as the cumulative damage from misvalued mortgage loans becomes increasingly harder to hide.  Before this starts to happen, most of the benefits of the initial lenders’ implicit subsidy for making overleveraged loans will have been taken out of the banking system.  Safety-net subsidies are distributed more or less as they accrue to shareholders (through dividends and share buybacks) and to top managements as performance bonuses.  Moreover, any manager who wants to pursue the safety-net subsidy to the max can place further high-risk bets by funding their firm’s mortgage holdings with short-term liabilities.  When mortgage holders do this during a prolonged boom, the losses hidden outside of institutions’ financial statements become ever more extensive as the funding interest rates they have to pay soar beyond the rates they earn on their mortgage portfolio.

One of the first things any economist learns is that taxes and subsidies are shifted to some degree forward to consumers and backwards to parties located in other parts of the supply chain.  In periods of macroeconomic expansion, the process of shifting generous mortgage-rate and safety-net subsidies into house prices helps to push housing prices upward, eventually to unsustainable levels.  At lending banks, a period of rising house prices inevitably triggers relaxed credit standards for qualifying would-be homebuyers for a mortgage loan.  But when house prices level off or begin to fall, lenders’ standards have to tighten again and the loans written during the last years of the boom are seen to be overpriced and evidence a loss in value.

In hopes of preventing these anticipatable losses from boring a huge hole in their net worth and to cash in some of their safety-net subsidies, securitizing bankers “sold” pools of mortgage loans at or near par to sister subsidiaries and affiliates as a way both to liquefy their claim to housing and safety-net subsidies and to move potential losses off their banks’ accounting balance sheets. Of course, these sales did not prevent the emerging shortfall in payments from unqualified borrowers from hurting their subsidiaries and affiliates.  Once housing prices stopped rising, managers of these short-funded pools of mispriced and often poorly structured mortgages found it hard to roll over their financing. Foreshadowing the onset of a full-fledged crisis in the US and Europe, the rollover risk encountered by short-funded mortgage-backed securitization vehicles became more and more concerning from July, 2007 on.

Dialectics of This Explosive Policy Mix

As a boom in housing prices proceeds, the cost of financing the subsidies grows and saddles more and more households with housing-related debt that is potentially more difficult to service than they realize.  To keep this debt from restraining household consumption and to keep the subsidies flowing, monetary policymakers feel political pressure to follow expansive policies that support employment, wages, and credit growth.

Table 1 models —in words rather than in equations— the life-cycle of a subsidy-induced crisis.  The narrative shows that the subsidy-driven boom in housing and the rising implicit cost of safety-net coverage do not start to be challenged until doubts about the government’s ability to manage the growing safety-net costs lead large creditors to engage in “silent runs” from banking-organization debt.  These runs are called “silent” because – unlike runs initiated by retail depositors – they create little or no concurrent publicity.  Still, by firmly testing banks’ ability to roll over their liabilities, they force asset sales and the issuance of new higher-priced liabilities.  These transactions begin to surface at least some of the losses imbedded in the financial system’s mortgage portfolio and net-worth.

The sequence of crisis events observed in most countries conform to the pattern of crisis generation and response shown in Table 2, generally stalling short of full cleanup at stage 4B or 5A.  The 2007-08 breakdown of arrangements for financing structured securitizations of US mortgages in the US and Europe show this pattern, as did the 1997-1998 banking crises that roiled through Latin America, Japan, Korea, the Philippines, Malaysia, Indonesia, Thailand, and Russia.[3]

The Pre-Crisis Stages of Aggressive Subsidy Pursuit and Regulatory and Supervisory Forbearance

Across the world, authorities confront asset-price declines in more or less the same ways. Although German, British, and American authorities showed a willingness to close smaller institutions, they also showed that, when it comes to a megabank, politicians are reluctant (if not genuinely afraid) to move beyond the stage of stopgap partial recapitalization stage (stage 4A). As long as the near-hopelessness of an institution’s situation can be covered up, outsiders cannot easily distinguish a wave of financial-institution insolvencies from a transitory shortage of aggregate liquidity. In either circumstance, what can be immediately observed is that a group of economically significant firms find it exceedingly difficult to roll over maturing debt on profitable terms. It is a culturally accepted first-response practice for central bankers and other regulators to provide liquidity to distressed institutions to buy time for supervisory staff members to investigate the extent to which irreparable insolvencies might underlie the distress. This bullsh*t time-buying strategy is supported by three exculpatory norms whose ethical force intensifies in times of political, market, or institutional turmoil: (1) a mercy norm; (2) a nationalistic norm; and (3) a non-escalation norm.

The mercy norm holds that it is bad policy and unacceptably cruel behavior for regulators to abandon the employees, creditors, and stockholders of institutions they oversee before they can convincingly establish whether the distress is too fundamental to be remedied by supervisory forbearance or subsidized loans. This norm gives regulators the discretion (if not the duty) to alleviate the initial pains of any client institution that experiences a silent run.  A related norm supports a preference for completely rescuing the creditors of institutions that seem difficult to nationalize or unwind.  To illustrate the sway of both norms, we need only cite the huge amount of relatively low-cost loans that the Federal Home Loan Bank System provided the hopelessly insolvent Countrywide Financial Corporation prior to its 2008 acquisition by BankAmerica.

The nationalistic norm presupposes that regulators should help domestic institutions and marketmakers to cope with foreign competition. In practice, this norm is reinforced by community resistance to foreign control of national credit decisions and by lobbying pressure from the politically favored sectors who suspect that foreign banks will not serve their interests very well.  The operation of this norm can be illustrated by the Fed’s successful efforts in 2008 to dissuade Deutschebank from competing with Morgan for the insolvent Bear Stearns franchise.

The nonescalation norm allows authorities to lend on subsidized terms to distressed institutions and even to operate insolvent firms (such as Fannie Mae, and Freddie Mac) as temporarily nationalized institutions.  To succeed in this, officials must popularize the view that doing anything else would invite a national or global financial disaster. In invoking this norm, officials must and do spread fear. They argue that, without a large injection of subsidized funds, market forces will do terrible things: set prices for troubled assets that are unreasonably low, set prices for private credit to institutions that hold troubled assets that are unreasonably high, and transmit these price pressures to strong and healthy institutions in ways that would throw them into turmoil, too.  Because regulators don’t really care whether these scary arguments are true, they qualify as bullsh*t.

Though customary, it is politically and economically dangerous for government officials to make these exaggerated claims and to deny the increasingly transparent flow of subsidies that partial recapitalization entails.  When and if an official is discovered to have been misrepresenting the need for and extent of the anti-egalitarian redistribution of wealth that bailouts entail, he or she faces the likelihood of being made a bullsh*t scapegoat for the mess as a whole.  For high-ranking regulators to want to keep churning out increasingly visible safety-net subsidies, two conditions must hold.  First, they must be able to control the flow of information, so as to keep taxpayers and the press from convincingly assessing either the magnitude of the implicit capital transfer or the anti-egalitarian character of the subsidization scheme.  Second, officials’ commitment to these policies must be continually nourished by praise and other forms of tribute from the bankers, borrowers, and investors whose losses are being shifted to less-influential parties.

Authorities are reluctant to undertake a full recapitalization until hidden losses make themselves felt as irrepressible popular pressure.  The longer the game goes on, the greater the risk that the reputations of incoming policymakers and the particular politicians that appoint them will be saddled unfairly with the sins of their predecessors. Although it is unwise to draw inferences from a small sample, the U.S. savings-and-loan mess and various Argentine crises cast some light on how unfairly costs are apt to be allocated during the final stages in the life cycle of a subsidy-induced crisis.

Global Implications of the Forbearance Process

In any country, the politics of crisis management favor whichever classes of bank stakeholders have the most to lose.  As a result of stakeholders’ differential ability to influence policy, the world has experienced a series of rolling and incompletely resolved crises that have kept most nations from approaching the vanishing point.  These developments should sound at least three alarms. First, the frequency, severity, and geographic extent of banking crises convincingly demonstrate that, around the world, many institutions found it reasonable to book potentially ruinous risks.  Looking at the period 1977-1995, Caprio and Klingebiel (1996) cite 58 countries in which the net worth of the banking system was almost entirely eliminated.  Extending the time period to 1970-2007, Laeven and Valencia (2008) found 42 severe (i.e., “systemic”) banking crises from 37 countries and their paper examines the different ways that policymakers chose to deal with them.  Second, in country after country, domestic (and sometimes foreign) taxpayers have been billed to bail out bank stockholders, creditors (including depositors), and deposit-insurance funds (Demirgüç-Kunt, Kane, and Laeven, 2016).  Third, the size and distribution of bailout costs is distressing.  Honohan and Klingebiel (2003) confirm that, in modern crises, taxpayers’ bill for making good on implicit and explicit guarantees typically ran between 1 and 10 percent of GDP.  The size of these bailouts establishes that, at least in crisis countries, banks managed to put large bets on the table and were able to shift a substantial amount of the downside of these bets to taxpayers.  Sometimes, but by no means always, authorities were eventually blamed for the size of the bills taxpayers were asked to pay.  But officials hate to be blamed for anything.  They make it hard for outsiders to establish definitively when supervisors recognized systemic problems and whether and how long they may have willfully shirked their obligations to expose loss-causing patterns of risk-taking in their regulatory domain and to take meaningful steps to control them.  The ability to hide what they knew and when they knew it gives supervisors political cover for losses that result from their reluctance to address major bank insolvencies until the taxpayers’ position deteriorated disastrously.

Whether supervisory mistakes are likely to be identified or not, in the midst of financial turmoil, industry lobbying pressure and weaknesses in ethical controls on the job performance of government regulators responsible for protecting the safety and soundness of financial institutions encourage regulatory forbearance.  The high cost of modern crises indicates that the willingness of safety-net officials to expand taxpayer exposures to risks from the safety net greatly exceeds that of large-denomination creditors.  Although institutional mechanisms for financing safety-net loans and guarantees differ across countries, information blockages and incentive conflict in government policymaking impede the fair and timely treatment of financial crises everywhere.

The appropriate policy response to crisis pressures depends on the nature of the policy contradictions that occasioned the crisis.  A perennial issue is to assess the potential insolvency of troubled institutions and to determine how rapidly their net worth is being undermined by falling prices on the subsidized loans that created the crisis.  Asset-price meltdowns are most likely to occur when incentives for over-lending by domestic and offshore institutions confront a national policy regime that offers incentives for over-borrowing at domestic households and firms.  In such cases, downward pressure on asset prices is apt to generate insolvency and a crisis-intensifying flight from claims issued by the overleveraged borrowers to overleveraged lenders.

Although the mercy norm makes it conventional for central bankers to pretend that the silent runs that triggered either the GFC or other crises are driven by a shortage of aggregate “liquidity,” creditor runs are usually driven by concerns about an institution’s solvency.  By the time a full-fledged crisis emerges, central-bank forbearance will have accommodated overspending in the favored-borrower sector for many years and probably also financed a long run of current-account deficits.  In a system of flexible exchange rates, central bankers can prolong a payments deficit by letting the country’s currency decline and/or by drawing down the country’s foreign-exchange reserves and foreign lines of credit.  In this kind of slow consumption-driven currency devaluation, the need to rebuild the central banks’ currency reserves may never seem urgent.  If it does seem urgent, authorities can shrink the current-account deficit in two complementary ways: (1) by allowing the exchange rate to decline even further and (2) by tightening their mix of fiscal and monetary policies.

But when a money-center country is experiencing a crisis, this prescription is unattractive. Either policy would impose a sizeable opportunity loss on foreign and domestic holders of the country’s financial assets.  The currency-adjustment half of this strategy would put inflationary pressure on domestic prices.  To pile these developments on top of the tight-money half of the prescription would induce a decline in aggregate economic demand, whose effects would reduce the real value of a country’s financial assets in general and the net worth of its financial system in particular.  This could further undermine asset values by raising prospective rates of default and delinquency on troubled assets. Still, in crisis circumstances, it is politically impossible for authorities to ignore the effects that macroeconomic policy adjustments have on safety-net loss exposures.

In a financial center country, authorities face a Three-Way Policy Dilemma about how to control a silent run:

  1. Choice One:  Try to finance the runs with minimal adjustment in the loss-causing parts of the policy mix.  We may characterize this strategy as deliberately dis-informational.  Authorities may temporarily nationalize one or more insolvent institutions and deny that many other zombies exist. They may or may not soften the potential decline in their exchange rate by swap arrangements, drawing down reserves, or borrowing from private and official foreign sources.
  2. Choice Two:  Rebalance the policy mix to make it more sustainable, but only with respect to a narrowly defined window of time (e.g., until after one or more the next few elections).  Authorities may resolve or strengthen some of the weakest zombie institutions and may also try to increase monetary growth.  We may describe this strategy as “partial recapitalization.”
  3. Choice Three (unlikely to be chosen unless prior efforts to use one or both of the other strategies have failed): Confront and eliminate the most obvious contradictions in the policy mix.  The new policy regime should aim for a full cleanup of insolvent institutions and to establish a more incentive-compatible supervisory system going forward.

In crisis circumstances, the chief aim of policymakers is rescue.  Politicians are strongly tempted to reflate demand and to strengthen the credibility of safety-net guarantees, without doing much to resolve the incentive distortions that widespread insolvency creates (Demirgüç-Kunt, Kane, and Laeven, 2016). In 2008, US regulators went initially with Choice Two, while European regulators opted for Choice One.  The S&L Mess had taught regulators in the US something that European regulators have yet to learn.  Although it is dangerous to acknowledge and resolve corporate and financial-institution insolvencies in the midst of a national recession, leaving insolvencies unresolved can be even worse.  Financial-institution and corporate insolvencies foster further mis-investment and enhance the likelihood that a still-deeper crisis will emerge down the line.  Not having learned this lesson firsthand, European banking officials are still in denial about the dangers posed by zombie megabanks.  Figure 1 provides day-by-day estimates of the subsidy being received by one of Europe’s largest zombie megabanks since late 2013.  Table 4 provides disturbing evidence about the current vulnerability of a number of others.

The Dodd-Frank Act Exemplifies Choice Two

Ferguson and Johnson (2009a and b) provide an extensive and insightful analysis of the associated regulatory failures that the DFA was “intended” to correct.  Aikman, Bridges, Kashyap, and Siegert (2018) document the build-up of household leverage and banking risks in advance of the 2008-09 crisis and provide evidence that post-crisis reforms could not (if they were in place prior to the crisis) have done much to stop this build-up.

Financial-institution lobbyists’ explanations of the factors that led to the GFC are much simpler than either of these analyses. Their presentations begin with the bullsh*t claim that “our guys” definitely didn’t cause the crisis and usually grant that the true cause might have been one or more of the following items:

  • Excessive statutory deregulation of the financial sector
  • Dishonest accounting
  • Rent-seeking or incompetent executives in other sectors of the industry
  • Dishonest credit-rating firms
  • Defective systems of housing finance
  • Overexpansion and misregulation of derivatives transactions
  • Mistakes in monetary policy.

Half-true lobbyist bullsh*t in, assured statutory bullsh*t out. I believe that the Dodd-Frank Act is best understood as a collection of policy measures designed to weave its way respectfully through these seven alternative theories of the crisis to incorporate a (sometimes lame) treatment of the forces featured in each of them.

What I find ironic in this massive and allegedly comprehensive legislation is that, as I have tried to show, the seven phenomena listed in the previous paragraph all trace to the interaction of the pair of implicit subsidies that my model highlights.  These subsidies are hidden in the systems used: (1) to finance housing investments on the one hand, and (2) to finance the US financial safety net on the other.  In turn, the norms that make these subsidies durable are rooted in a generalized breakdown in professional ethics that the DFA does not treat at all. The professions of government service, accounting, financial management, credit rating, mortgage banking, derivatives broker-dealermaking, and government regulation all have explicit or implicit codes of practice that (wink, wink) members of the profession are expected to follow prevent client, user, or societal abuse and to preserve the integrity of that profession.

In some countries and professions (especially medicine), violations of particular standards that impose predictable harm on other parties become a matter for law enforcement. So (I believe) it should be in finance.

Focusing Only on Bank Capital is a Loser’s Game

Along with investments in political clout, bank managers can make themselves Too Big to Discipline Adequately (TBTDA) by: (1) moving highly leveraged loss exposures formally off their accounting balance-sheet, and (2) maintaining an aggressive program of mergers and acquisitions.  Over time, either strategy makes a large institution ever more gigantic, ever more complex, and ever more politically influential.  The profitability of undertaking these dialectical responses to banking laws and regulations is documented in Table 1 and Figure 3.  To me this is evidence that the current wave of financial-institution consolidation, and convergence is not just an efficiency-enhancing Schumpeterian long-cycle response either to past overbanking or to secularly improving technologies of communication, contracting, and record-keeping.

Any time a TBTDA organization becomes larger or extends its safety-net guarantees over a new product line, its managers are likely to see an increase in the capitalized value of the implicit government credit enhancements imbedded in their bank’s capital structure (Kane, 2000; Penas and Unal, 2004; Brewer and Jagtiani, 2007).  Simply put, consolidation and expansion create additional value for large institutions by reducing the contestability of the markets in which they operate by eliminating competitors, strengthening exit resistance, and creating opportunities to extend their branch networks pre-emptively into locations that might otherwise have been able to attract unrelated new entrants.

One can only wonder how rapidly the market’s appetite for structured securitizations would have grown if opaque off-balance-sheet vehicles such as Structured Investment Vehicles (SIVs) had not offered implicit safety-net benefits and supervisory cover to their sponsors.  Controlling safety-net subsidies to risk-taking by opaque and nimble financial firms is tough enough.  But it is fiendishly difficult for incentive-conflicted agency leaders to control risk-shifting at firms that capital markets perceive to be macroeconomically, politically, or administratively too difficult to close and unwind.  For megabanks, the Basel approach of setting capital requirements only against what have become well-understood and easily measureable exposures is massively inadequate.

To mimic the methods by which private counterparties keep opportunities for risk-shifting under control, capital requirements have begun to introduce special surcharges designed to increase both with an institution’s size and with the opacity of its deal making.  But further reform legislation passed in 2018 benefits giant banks in two ways: by doing nothing new to rein in their ability to command safety-net subsidies when they are in distress and by expanding access to these subsidies for their custody activities. As always, an unreformed and elitist justice system continues to grant megabankers near-impunity for forcing the safety net – rather than their stockholders— to finance their firms’ deepest risk exposures. Managers of temporarily well-capitalized banks routinely pressure regulators to let them use dividends or stock repurchases to distribute as much of their current earnings as they can.

Worse yet, regulators add their blessing to bankers’ bullsh*t claim that this is okay because low current levels of safety-net subsidies mean that safety-net subsidies are safely under control. While it is true that the value of safety-net guarantees is relatively low at US megabanks today, this is because safety-net subsidies recede as a bank begins to build up its capital even a little (Figure 1). But the Regulatory Dialectic explains that, contrary to Adamanti and Hellwig (2013), increased capital requirements and incentive-conflicted stress tests cannot keep taxpayers’ loss exposure in megabanks under control for long. Whatever the level of capital requirements, taxpayers’ stake increases when and as bankers find new and better ways to hide leverage, tail risk and distress from their supervisors (Hovakimian, Kane, and Laeven, 2015).

Stress tests add an overlay of bullsh*t and belief perseverance to this process.  It looks as if regulators have stopped using these tests to assess the volatility of taxpayers’ stake in large banks.  Beginning this year, the Fed appears to have repurposed the tests as a way to provide supervisory cover for captured regulators to permit the megabanks to use share buybacks and dividends to pay out enough of their accumulated profits to drive their safety-net subsidies up again.

Stress-tests protocols and the enhanced resolution regimes envisioned in postcrisis reforms seek to increase the dosage and complexity of capital-requirements medicine and to prescribe it for a larger range of firms. But by themselves, tougher capital requirements are not a disincentive because they do not directly punish the architects of safety-net abuse. Instead, they challenge offenders with new constraints whose enforcement is expected to prove toothless when and if the supervisory system is once again tested by a spreading crisis.

Stress tests ask whether selected ratios can cover —not current-dated liabilities—but the degree of distress a bank’s capital might be required to absorb during the next nine quarters if the bank’s business and capital-distribution plans were put through a hypothetical “scenario” of adverse financial shocks and difficult macroeconomic events.

The test procedure is now called DFAST (Dodd-Frank Annual Stress Testing). The follow-on (and qualitative) interpretation and friendly re-grading of DFAST results for major US banks – which is carried out by staff at the Federal Reserve Board— shades into what is called the CCAR (Comprehensive Capital Analysis and Review).

Where’s the Bullsh*t in this Instrument?

It is hard to demonstrate that this statutory expansion in post crisis control and supervision has actually helped taxpayers. The DFAST and CCAR protocols and criteria are improvisational and lacking in statistical rigor both in their construction and in their application. Neither the scenarios nor the prudential standards employed in the stress tests are constructed in a reproducible manner. Neither makes explicit use of probability distributions for the future prices of the assets and liabilities that define the measure of bank’s capital used, even though the volatility of these prices is what is ultimately at issue.

This absence of empirical foundations gives regulators and megabank executives considerable leeway for explaining away whatever shortfalls the tests uncover. Finally, regulatory norms of rescue and helpfulness for troubled firms tempt authorities to find ways to inflate the grades and soften whatever punishments might be visited on falling firms. The traditional way to inflate a bank’s examination grade is to overvalue soured assets and to undervalue liabilities whose market values might be soaring above par.  A less obvious way is to invent new categories of intangible assets.

An example of how creatively accountants can create intangible assets is buried in the excuses bankers and regulators have used to downplay the significance of the low grades that the weakest megabanks achieved in the 2018 tests. The press was told that the 2018 tax cuts severely reduced regulatory “capital” at CCAR banks because it greatly lessened the value banks expect to derive from being able to write off past losses against yet-unrealized future income.

That the outcome of several banks’ past stress tests turned on such a gimmick should be deeply disturbing. Authorities should have explained that the fabricated nature of this asset class had unfairly biased CCAR grades upward not only now, but in the past. Instead, authorities sought to transform this revelation into a lame excuse for granting further leniency.

Stress tests are intended to assure the public that banks have prepared themselves for the next crisis. It is dishonest to pretend that tax-loss carryforwards could act as loss-absorbing capital in either a crisis or near-crisis scenario. These hypothetical assets are a counterfeit (i.e., bullsh*t) source of loss- absorbing capital because they have virtually no liquidity in a stress scenario. In a crisis, no market exists that can promptly convert future tax write-offs into cash. At an insolvent bank, except for the intangible value of safety-net support (which expands), the net worth of tax-loss carry-forwards and most other intangible positions nearly vanishes.

Are the Post-Crisis Regulatory and Supervisory Systems Resilient Enough?

Most commentators argue that US megabanks are safer now that they were in 2007-2008.  But a more-important and unasked question is: For how long?  Figure 8 tells us that the process of rebuilding leverage-driven tail risk by means of dividends and stock buybacks is already well underway.

Equally worrisome, bank information systems do not try to track taxpayers’ stake in banking firms and the regulatory, supervisory and justice systems remain focused on disciplining banks, rather than bankers.  As long as these conditions hold, bankers will continue to use the safety net to enrich themselves and their shareholders at our expense.


[1] According to Frankfurt (2005), bullshit differs from lying in that the bullshitter ignores the truth instead of acknowledging and then subverting it. Among my childhood friends, that was our definition of horseshit, to which the bullshitter adds an intention for his horseshit to be taken seriously. For example, Rep. Blaine Luetremeyer (Missouri) –who tops the list of House recipients of bank support in the more-recent election cycle—repeatedly asserts that small banks “were not part of the problem” that caused the Great Financial Crisis and that rolling back the Dodd-Frank Act would greatly improve customer access to credit and lower its cost (Kline, 2018).

[2] Since leaving office, Fed Chairman Alan Greenspan has expressed regret for having produced this particular kind of misinformation.

[3] For detailed listings and analyses of late-20th century crises, see Caprio and Klingebiel (1999), Honohan and Klingebiel (2000), and Beim (2001).

See original post for references

Due to the fact that WordPress was already choking on this post due to its length, I had to omit the terrific supporting material that Kane provided at then end, such as “DESPITE THE BULLSH*T ADOPTION OF NO-BAILOUT POLICIES BY THE EU, DEUTSCHE BANK AG HAS REMAINED A ZOMBIE, EVIDENCING SAFETY-NET SUBSIDIES MOST OF THE TIME.” I hope you’ll visit the post and scroll to the end to look at the information.

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  1. Tomonthebeach

    After just reading Taibbi’s article in Rolling Stone, this article itself is a double-whammy. It surely seems to be that Economists are voices crying in the wilderness far from the awareness of Capitol Hill legislators – still drunk on the WS Kool-aid their re-election campaigns just gulped.

    1. John Wright

      I don’t believe it is accurate to say “Economists are voices crying in the wilderness”

      In my view, your statement should be modified as “a very few Economists are voices crying in the wilderness”

      The vast majority of economists are fully vested in the current order, which remains ignore financial problems and if a financial problem crisis surfaces, use government resources to clean it up as the loss is socialized.

  2. Sound of the Suburbs

    The FT had a chart recently that showed financial crises were very few and far between in the Keynesian era.

    Before the Keynesian era they used neoclassical economics, and after the Keynesian era we used neoclassical economics.

    The two elements of neoclassical economics that come together to cause financial crises.

    1) It doesn’t consider debt
    2) It holds a set of beliefs about markets where they represent the rational decisions of market participants; they reach stable equilibriums and the valuations represent real wealth.

    Everyone marvels at the wealth creation of rising asset prices, no one looks at the debt that is driving it.

    The “black swan” was obvious all along and it was pretty much the same as 1929.

    1929 – Inflating US stock prices with debt (margin lending)
    2008 – Inflating US real estate prices with debt (mortgage lending)

    They are called Minsky moments.

    The Chinese have worked this out as they revealed at Davos this year.

    This is why the Chinese saw their Minsky moment coming, unlike the Americans.

    The two indicators of a coming financial crisis are the private debt-to-GDP ratio (see above) and over inflated asset prices.

    The Chinese regulator in the video above has looked at the fundamentals and has realised US stocks are at 1929 levels again. The West’s experts can’t change the subject fast enough when the Chinese regulator points out this epic blunder (49 mins.).

    The FED calls this a “wealth effect”.

    The Chinese see it as an indicator of a coming financial crisis.

    1. Sound of the Suburbs

      After the Keynesian era we threw the baby out with the bath water.

      They used neoclassical economics in the 1920s.

      They found out what was wrong with neoclassical economics in the 1930s.

      Neoclassical economics came back in the 1980s and everything that had been learnt in the 1930s was forgotten. The baby went out with the bath water.

      Refresher course.

      In the 1920s, the bankers inflated the US stock market with margin lending.
      In 1929, the markets corrected.

      After 2008, the central bankers inflated the markets with QE.
      What happens next?

      If the central bankers had remembered the lessons of the 1930s they would have got the real economy going to drive the markets higher through fundamentals.
      The markets don’t need to correct later.

      1. Hayek's Heelbiter

        “…everything that had been learnt in the 1930s was forgotten.”

        Kondratiev had it right with his negative waves. 75 years appears to be the length of time that people seem to remember hard economic lessons and jump right in to prove that Santayana’ was right all along.

        Disclaimer: I was reading THE DAILY MAIL this morning (please, not negative comments) recapping the Lehman crisis and realize that we should rename those responsible for these repetitive crises not as “banksters” but as “bonkers” [meaning “insane”] and their primary activity is “bonking” the 99%. You get the general idea, maybe FOUR WEDDINGS table tennis with us punters as the balls.

    2. perpetualWAR

      No kidding they couldn’t change the subject fast enough. The Western economist that interrupts the Chinese regulator actually talks about his sagging body from gravity! Sort of unbelievable how fast that subject was dashed.

  3. Sound of the Suburbs

    What we needed to know before globalisation.

    How can bankers use their debt products to create real wealth and increase GDP for growth?

    The UK:

    Before 1980 – banks lending into the right places that result in GDP growth
    After 1980 – banks lending into the wrong places that don’t result in GDP growth

    The UK eliminated corset controls on banking in 1979 and the banks invaded the mortgage market and this is where the problem starts.

    Richard Werner was in Japan in the 1980s when it went from a very stable economy and turned into a debt fuelled monster. He worked out what happened and had all the clues necessary to point him in the right direction.

    Bank credit (lending) creates money.

    The three types of lending:

    1) Into business and industry – gives a good return in GDP and doesn’t lead to inflation
    2) To consumers – leads to consumer price inflation
    3) Into real estate and financial speculation – leads to asset price inflation and gives a poor return in GDP and shows up in the graph of debt-to-GDP

    Bank credit has been used for all the wrong things during globalisation.

    1929 – Inflating the US stock market with debt (margin lending)
    2008 – Inflating the US real estate market with debt (mortgage lending)

    Inflating asset prices with debt (type 3 lending).

    Creating real wealth and increasing GDP (growth) requires type 1 lending.

  4. nothing but the truth

    every bailout is basically a floor on P/E ratios of assets.

    it is asset owners who are primarily being bailed out.

  5. TheScream

    Never Fear, Yellen is here! Here latest solution to crises is golden. Just keep pumping and then pump harder and longer. Yep, Yellen has officially morphed the Greenspan Stable Economy into the Yellen Rollercoaster. She wants the Fed to admit that the economy (Wall Street) is out of control and it will steal trillions and then crash the economy over and over and over again. And the only thing to do is print more money to keep the bankers happy.

    Is anyone out able to get his hands on one of Jimmy Carter’s neutron bombs? One of those would cure the Wall Street Disease and high real estate prices in Manhattan in one fell swoop.

  6. Alex morfesis

    But what if as secret ancient aliens technologists suggest…Basel 2 and the German dance…mittelstadt enterprises sell overpriced but long term useful products to keep the avg German from noticing their demographic timebomb…except one needs someone to actually buy the product…which required financing…with German focus on second world and third world economies, the local banking systems are hand cuffed by hardly useful or non existent capital markets not allowing the illusory creation of “market cap equity” available to the oecd banks…thus a need to create false spreads to book profits but then what to buy that was Basel 2 compliant…one of the things that went unnoticed by most was the involvement of landesbanks in guaranteeing the payment streams of the various financial gearing and engineering schemes that were needed to feed the capital needs of the non oecd banks who were funding the German mittelstadt enterprises sales…either way…everybody loves Germany no matter the Berlin bankruptcy, the demographic apocalypse and the fact they sell solid but over priced stuff…they are the economic darlings of the oecd…able to suggest they do not have large govt borrowings on the “National” level while ignoring how they bailout their local governments…

    ’tis what it is…

    The crash came literally the week razputin pushed back on Germany and their favorite Chihuahua McCain in Georgia… Stopping the merrygoround game of ever German expansion…
    Personally… Methinks Everyone ignores Indonesia and co. to their peril…

    Turkey, Indonesia, Vietnam, the Philippines, Brazil, Egypt and Nigeria…

    The incredible 7….

  7. bruce wilder

    It took me a while to work my way thru this long, but dense analysis, but, as impressed as I am by the ambition, I find the economic analysis to be fundamentally incoherent.

    The fault, it seems to me, is in the counterfactual presumption that there is a right “interest rate” that would obtain in the absence of the complex administration of “subsidies”: Professor Kane writes,

    “To see how this works, let’s assume that (if not for the housing-finance subsidy) the default and liquidity premia in a loan portfolio accruing 6 percent actually called for a market interest rate of 7 percent.”

    In informal expositions of neoclassical economics, it is often presumed that the self-regulating “market economy” can generate a general “competitive equilibrium” of optimal prices. Hayek’s polemical essay, “The Uses of Knowledge in Society”, became foundational to neoliberal ideology, because it gives legitimacy to the myth of market price as a sufficient statistic. The nonsensical “loanable funds” theory is held in place by the unfounded insistence that interest rates equilibrate supply of savings with demand for investment. Which is a short-form way of saying, what Professor Kane is doing at the core of his otherwise admirably ambitious analysis is fundamentally inadmissible. This is not the right way to think about interest rates as prices in what is an elaborate administrative structure of control.

    I think Professor Kane has gotten a lot right in his essay: it is a game, in which public and private actors play strategically, to alter complex institutional structures in ways that have subtle implications and private benefits in the present and sometimes catastrophic consequences for the public interest in the long-run. Corruption of the institutional structure of control is a source of social risk amplification in a system that ought to function to enable individuals and businesses to manage risk while dampening risks for the society cum economic system as a whole. But often does not, because induced volatility is profitable for certain private actors well-placed to engage in accounting and management control frauds, and not incidentally, to induce regulators (public and private) to overlook those frauds as they are initiated and expand.

    To try to think productively about the pathologies of this system, it is not really helpful to reference in any way the misguided ideology of the ideal competitive market economy so beloved by neoliberals. The core problem is not that the actual interest rate on some loan deviates by x basis points from some putative natural interest rate that would, by being higher than the “subsidized” interest rate, correctly “imbed” default premia and liquidity premia. Interest rates do not work like that, as I would hope Professor Kane understands. In fact, prices in general do not work like that. In the real world, prices are administered by hierarchical systems of control — that’s why we worry about corruption and control fraud — and no price or schedule of prices constitutes by itself a sufficient statistic. That’s why we have other statistics — bond ratings and credit scores and on and on, and they are not sufficient either. All prices are contingent, embedded in schemes of rights and warranties and no where is that more true than in finance, where there is no constructive good being exchanged, only the contingent rights and warranties of the “deal” as Professor Kane terms the exchange. The bank or other financial institution originating a loan at some interest rate (relative to other interest rates), if ideally uncorrupt, is primarily engaged in trying to avoid making a toxic investment that will realize loss. The problem for the public regulation of finance is to constrain the system of finance from making loans that are privately profitable but socially toxic, aka predatory or parasitical.

    I think Professor Kane is right that the system of public regulation is complex in ways that unnecessarily obscure the difficulty of aligning the operations of private finance with public purpose, but his rhetoric attacking “subsidy” misdirects attention. If you want to engage in counterfactual speculation, imagine a truly laissez-faire system of private finance, and tell me, what would distinguish it from usury and loan-sharking? The art of the deal becomes the pure art of the con.

    The right place, imho, to direct attention would not be “the subsidy” but, rather, the distribution of “economic rents” implicit in the structure of banking and finance. Neoliberal ideology gets a lot of mileage out of using “rent-seeking” as a pejorative without considering what functions economic rents serve in structuring the economy and Professor Kane, true to form, casts aspersions on “rent-seeking” without adequately explaining what economic rents are or why public authorities might want, strategically, to grant modest economic rents as a way of structuring the financial sector, in ways that ensured a diversity of opposed interests and limited the size and scope of key private actors.

    The neoliberal worship of the impossible ideal of the self-regulating “competitive market economy” led to a deregulatory program for finance in the U.S. that knocked away the rules that gave various types of financial institutions defensible economic rents and set off a race to become too big to fail by any means necessary, a dynamic that ought to be given a lot more attention in Professor Kane’s analysis. Without economic rents to fall back upon, institutions whose leadership ought to be conservative and parochial in defending those distinct sources of rent, were left with no choice but to gamble on becoming part of institutions and systems larger in scope and size. Integrity ceased to matter, because it no longer protected an economic rent and common control of competing or opposed specialists was just an opportunity. He should be asking what distinguishes a credit union from a commercial bank, or a local community bank from an investment bank, or a real estate appraiser from a loan officer, or a mutual insurer from a for-profit insurer, or a financial auditor from a corporate executive, or gives any of those actors opposed interests in something valuable to lose. Extinguishing defensible economic rents in the name of neoliberal “competition” undermined the structure of finance in ways that no amount of macro-prudential regulation by far-seeing regulators on the heights is going to retrieve.

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