A Framework for Bailout Regulation

During the height of the financial crisis in 2008 and 2009, the government bailed out numerous corporations, including banks, investment banks, and automobile manufacturers. While the bailouts helped end the financial crisis, they were intensely controversial at the time, and were marred by the ad hoc, politicized quality of the government intervention. We examine the bailouts from the financial crisis as well as earlier bailouts to determine what policy considerations best justify them, and how they are best designed. The major considerations in bailing out and structuring the bailout of a firm are the macroeconomic impact of failure; the moral hazard effect of the bailout; the discriminatory effect of the bailout; and procedural fairness. Future bailouts should be guided by principles that ensure that the decisionmaker properly takes into account these factors. INTRODUCTION Since the financial crisis of 2008, the word "bailout" has become a term of abuse in our political lexicon. The bailouts of numerous financial institutions and two automobile manufacturers were extremely controversial. (1) Congress sought in the Dodd-Frank Act to ensure that bailouts would never take place again, going so far as to write into the preamble that one purpose of the Act was "to protect the American taxpayer by ending bailouts." (2) President Barack Obama agreed that "because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes." (3) But after his former Treasury Secretary admitted that Dodd-Frank would not end bailouts, Republicans in the House of Representatives issued a scathing report entitled Failing to End "Too Big to Fail": An Assessment of the Dodd-Frank Act Four Years Later A The political unpopularity of bailouts is matched in the academic literature, where the traditional view is that bailouts are almost always unwise, and usually result from political failure. (5) But the word "bailout" is used in different ways, and it is sometimes hard to understand what people are complaining about. A bailout is, essentially, a transfer of money or other resources from the government to a private agent (or sometimes to another government). Such transfers occur every day and hardly ever cause anyone to lift an eyebrow. The government transfers money or other valuable consideration to solar panel manufacturers, daily farmers, poor people, and research universities. While many people disagree about the wisdom of these transfers, they do not regard them as illegitimate in the same way that they often regard bailouts. We can make some progress by observing that in common parlance the word bailout refers to a subset of transfers where the transfer is intended to rescue an agent who cannot meet its financial obligations. Even here, however, the source of complaint is obscure. If the government is willing to subsidize a manufacturer of solar power panels by giving it money, making loans to it, or guaranteeing its debt (as it often is), then what's wrong with a policy of paying off an unpaid debt if otherwise it would default? The effect of all these policies is the same: to lower the cost of capital for the beneficiary. The policy justification is also the same: to encourage people to invest in solar power. Indeed, the government routinely helps agents who are about to default on debts. The Federal Deposit Insurance Corporation (FDIC), for example, insures people against loss of their deposits up to $250,000.6 If a bank fails, the FDIC transfers money to depositors, in this way paying the bank's debts (or some of them) for it. Similarly, if a natural disaster strikes, the government frequently assists victims by supplying them with loan guarantees and other benefits that make it easier for them to pay off their debts while they are rebuilding their lives. (7) FDIC payments are not called "bailouts"; why not? One reason is that the payouts are part of a regulatory program that puts burdens on banks and depositors. …