The GAO released the first of a two-part report examining the various aspects of government support in bank holding companies since the financial crisis. This report focused on the progress that the government has made (limited progress) towards preventing itself from providing special help to banks in the event of another financial or liquidity crisis. In this report, the GAO examines (i) actual government support for banks and bank holding companies during the financial crisis, and (ii) recent statutory and regulatory changes related to government support for banks and bank holding companies. The GAO reviewed relevant statutes, regulations, and agency documents, in addition to bank program transaction data. Also, the GAO interviewed regulators, financial institution representatives, and academics in order to compile a comprehensive foundation to inform the report.
The GAO found that relevant provisions of Dodd-Frank remain at best partially implemented and the effectiveness of those provisions remains uncertain. The report stated that agencies have finalized certain changes to traditional safety nets for insured banks, yet the impact of the provisions to limit the scope of transactions that benefit from these safety nets depends on how they are implemented. The GAO recommends that agencies (specifically, the Federal Reserve) establish timelines for completing their processes for drafting procedures related to emergency lending authority to ensure “timely compliance” with Dodd-Frank requirements.
There are a number of incidental aspects of the GAO report that are more interesting than the main topic of the report, which is the direct costs to the government of providing liquidity to the financial system at the time of the financial crisis.
Here is the GAO’s explanation of the principal cause of the financial crisis crisis (at page 11):
“The 2007-2009 financial crisis was the most severe that the United States has experienced since the Great Depression. The dramatic decline in the U.S. housing market that began in 2006 precipitated a decline in the price of financial assets that were associated with housing, particularly mortgage-related assets based on subprime loans (emphasis added). Some institutions found themselves so exposed to declines in the values of these assets that they were threatened with failure-and some failed-because they were unable to raise the necessary capital as the value of their lending and securities portfolios declined. Uncertainty about the financial condition and solvency of financial entities led banks to dramatically raise the interest rates they charged each other for funds and, in late 2008, interbank lending effectively came to a halt. The same uncertainty also led money market funds, pension funds, hedge funds, and other entities that provide funds to financial institutions to raise their interest rates, shorten their terms, and tighten credit standards.”
This seems rather at odds with the justification for much of Dodd-Frank: that hedge funds and swaps were to blame. But, the GAO report does not address why it should be a good idea to prevent the Federal Reserve from bailing out financial institutions at the time of a massive liquidity crisis. According to the GAO report (at page 1), “government interventions helped to avert a more severe crisis. . . ” Query, Should Congress, which in the past was not able to prevent a financial crisis, prevent a future Federal Reserve from responding in a way that seems most prudent at the time. If the market is absolutely convinced that the Federal Reserve will not provide liquidity in a financial crisis, doesn’t that make a crisis far more likely to occur because the market will panic faster if it believes that the government will simply let the banks fail?
