Double Whammy: Implicit Subsidies and the Great Financial Crisis

Abstract

This paper concerns itself with the joint effect 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, the stealthy way banks have pursued these subsidies allowed hidden leverage and arcane loss exposures to build up to a disastrous degree.

When lenders' safety-net support was finally tested by creditor runs, the struggle to reallocate losses and loss exposures away from the banks that had concealed them pushed the world's financial system into open crisis. Post-crisis regulatory reforms seem to have blunted the force of these subsidies, but the instruments assigned to this task are too weak to work for long. With the connivance of regulators, US megabanks are already re-establishing their ability to use dividends and stock buybacks to rebuild their leverage back to dangerous levels.

Meantime a number of European megabanks (exemplified by Deutsche Bank) have remained in a zombie or near-zombie condition throughout the last decade. In the coming years, these banks' perilous condition and the possibility of extending safety-net coverage to support subsidized loans for bankrupt students, pension funds, and state and local entities could easily trigger another crisis.

Besides trying to avoid future crises and directing bailouts when a crisis occurs, top regulators seem to believe that an important part of their job is to convince taxpayers that the next crash can be contained within the financial sector and won’t be allowed to hurt ordinary citizens in the ways that previous crises have. This paper seeks to convince readers that, until the law begins to hold individual bankers civilly and criminally responsible for using the safety net to enrich themselves by recklessly putting their banks' survival at risk, these rosy claims are bullsh*t.

Keywords: Too big to fail, financial safety, financial reform, financial crises, implicit subsidies, political economy

JEL Classification: E02, E32, E42, E52, E58