Several recent news stories have covered the efforts of some large financial institutions to repay the funds they received from the federal government under the Troubled Assets Relief Program. Executives of these firms are chafing under the costs resulting from acceptance of these funds, which in some cases they did not accept voluntarily.
The federal government is imposing conditions on repayment that mean recipients cannot get out from under the TARP without the federal government’s permission. What lessons can be learned from this experience?
Financial Times reporters Krishna Guha and Daniel Dombey write:
Strong banks will be allowed to repay bail-out funds they received from the US government but only if such a move passes a test to determine whether it is in the national economic interest, a senior administration official has told the Financial Times.
Previously, the Treasury Department’s “stress tests” have been understood to be limited to the financial stability of the bank itself. Not any more:
“Our general objective is going to be what is good for the system,” the senior official said. “We want the system to have enough capital.”
The objective function for a bank’s stress test has fundamentally changed. It does not matter whether the bank can withstand specified financial stress; what matters is whether the Treasury Department can withstand the stress of a strong bank leaving the TARP.
Last fall, financial institutions received federal capital infusions in return for giving up majority ownership. In many cases, these capital infusions were necessary for corporate survival. But executives of some institutions believed that they did not need the money and actively resisted accepting it. They were compelled to do so by then Treasury Secretary Hank Paulson, who wanted all institutions to receive capital so that markets could not discern weak from strong institutions.
The logic held that the ability of markets to discern weak from strong banks constituted a systemic financial risk. That is, it was feared that markets left alone would be brutally efficient, and the threat of efficiency posed a grave threat to the US and world economies.
Whatever the merits of this argument, the government’s effort to disguise weak financial institutions failed. Markets long ago figured out how to discern them. The FT story indicates that government control of TARP recipients is now founded on a new logical argument: strong firms cannot be allowed to escape TARP as long as the government faces significant risks from weak ones:
The official, meanwhile, said banks that had plenty of capital and had demonstrated an ability to raise fresh capital from the market should in principle be able to repay government funds. But the judgment would be made in the context of the wider economic interest. He said the government had three basic tests. It needed first to “make sure the system is stable”. Second, to not create “incentives for more deleveraging which would deepen the recession”. Third, to make sure the system had enough capital to “provide credit to support the recovery”.
Thus, a bank’s ability to repay TARP funds “in principle” is not sufficient. Rather, it must be able to do so without exacerbating the recession or increasing the government’s remaining TARP-related risks.
These are very high hurdles. TARP is a mandatory government insurance scheme for financial institutions in which the government is the only insured party. It needs good risks to subsidize bad risks. Good risks cannot leave the pool because their departure necessarily increases the remaining risks. Therefore, strong banks cannot escape TARP unless and until the federal government decides that it is willing to accept these higher risks.
The government has very weak incentives ever to accept higher risks. That means at least until the government begins allowing strong banks to exit TARP, federal ownership of the US financial system should be viewed as permanent.