Hundred Years of Bailouts

by Chidem Kurdas

After all that’s been said and written about financial crises, it is rare to come across useful insights.  Financing Failure. A Century of Bailouts by Vern McKinley documents a major continuity with past policy making. He shows that policies intended to prop up failing companies are nothing new—the same basic pattern has recurred time and again.

But there is one notable change: the bailouts grew ever larger and the agencies concerned with them ever more numerous. Anyone thinking about recent crises and future prospects would do well to keep these points in mind. 

The book draws parallels through the decades. Some examples go from the early 20th century right through the 2008 crisis. Thus Continental Illinois National Bank was failing in the 1930s , mainly because of bad loans to utilities in the Chicago area. In 1933 the Reconstruction Finance Corp., a federal entity created by Herbert Hoover, bailed out Continental Illinois with $50 million. The bank failed again in the 1980s and was bailed again, this time with $4 billion under the FDIC’s special powers. Then Bank of America acquired the remains of Continental Illinois. You will recall the $45 billion federal support for Bank of America after its purchase of the failing Merrill Lynch four years ago.

Mr. McKinley, a policy expert and research fellow at the Independent Institute, remarks:  “One has to wonder what form the firm will take when it is bailed out during the next financial crisis later this century.”

Chapters on the 1930s and 1980s form the core of the book. Having presented the history, the author connects the dots. Politicians and regulators presume all is under control; when a crisis appears they panic and rush to take some sort of action. Thereby they enact the logical fallacy immortalized in the British sitcom, Yes, Prime Minister: “We must do something; this is something; therefore we must do this.”

So after every financial turbulence Washington comes up with another raft of interventions, bureaucracies and committees to prevent crises—the latter range from the Federal Reserve, founded in 1913, to the Working Group on Financial Markets, set up in 1988, and the Financial Stability Oversight Council, created in 2010. The intention is to stabilize the system but the long-term consequences are less benign.

Mr. McKinley writes: “the number of agencies deploying bailouts multiplied, the safety net became bigger and bigger, and the primary beneficiaries were soon concentrated among the largest of financial institutions, who came to rely on and demand this ready source of government backstopping…” That distorts investment decisions and risk taking, eventually fueling another crisis. The cycle repeats. Another notch is added to the trend for more government backing.

What to do? Shut down failing banks rather than buttressing them, the book concludes. That is much easier said than done; Mr. McKinley does not delve into the political realities that encourage bailouts. Nevertheless, everybody with an interest in financial regulation should read his account of how the new TBTF is the old TBTF with a few added bells and whistles.

7 thoughts on “Hundred Years of Bailouts

  1. Thanks for the review. I notice that a lot of the economics comments aren’t quoted, meaning they’re yours. Does McKinley draw deeply from economics, or is the book mostly historical?

  2. What is most interesting is how unnecessary the bailout of Continental 1984 was. Its study provides insight into how false it is that Government needs to “do something” about systemic risk.

    Simulation runs on CINB’s case were carried out in a report by a House Committee to consider what would have happened if the FDIC had been restricted to its official mission. With the assumption that the loss rate of Continental was 10%, more than twice the actual rate, no bank would have gone immediately insolvent as a result of these losses, and only two banks would have suffered losses in excess of 50 percent of their capital. Since the actual losses to the creditors were less than 5%, no counterparty contagion would have prevailed. There would have been no interconnectedness systemic risk whatsoever.

    On the other hand, we do have evidence of informational contagion. Swary (1986) studies the events following the CINB bankruptcy. His findings are such that the sub-sample of his study group exposed to risks similar to CINB (Latin-American debt) and in a state of questionable solvency did suffer higher abnormal losses and largely higher trade volumes. Since this reaction occurred after the announcement that all CINB creditors would be protected, and that this announcement was credible, the findings are consistent with the informational contagion theory. The failure of CINB likely revealed information on risks that CINB and Swary’s sub-sample shared in common. Wall and Peterson (1990) study the same events, with increased attention to detailed time-line of announcements on Latin-American debt, and confirms that movements are better explained by other risks than counterparty losses from CINB’s bankruptcy.

    So, the empirical literature on CINB’s failure provide evidence that there was no risk of counterparty contagion, but that some level of informational contagion has been involved. In any case, this informational effect does not seem to have been of such intensity as to alone spark any failure in the banking sector. CINB’s 1984 bailout was absolutely unnecessary.

  3. I read the book recently and it does not significantly invoke econ theory, as I recall. I just went back and leafed through. The index doesn’t have an entry for Keynes or Mises or Hayek and only one for Friedman. What the book shows over and over again is that regulators fail to use effectively or judiciously the powers they have, but the response to each crisis is generally to give more power to more regulators.

  4. Jon Finegold–

    This is a book on economic history, more specifically policy history. That history has economic and political implications, drawn at the conclusion. As Allan Walstad writes above, it does not go into economic theory.

    As for what’s in quotes in the review, If I’ve paraphrased a point or made it in a different way, obviously that will not be in quotation marks, but it is in reference to or inspired by the book.

  5. Thanks, Chidem, for drawing attention to McKinley’s book. TBTF is one of the more pernicious policies preventing any real movement toward any system approximating sound money. McKinley’s narrative captures the sort of “regulatory dialectic” that not only generates more systemic risk but seems now to be so deeply embedded in conventional wisdom that sensible reform is sadly a non-starter.

  6. Bill Butos–
    Yes, it does seem to have become part of conventional wisdom.

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