Political risk comes home to roost

Usually the term “political risk” is restricted to discussions about emerging markets, but one well-known economic commentator says the United States bailout of large financial firms has given political risk a new meaning.

William Poole, a senior fellow with the Cato Institute and the former president and CEO of the Federal Reserve Bank of St. Louis, made the argument at the CFA Institute’s Annual Conference in Orlando, Fla., that the bailouts of large financial firms — such as AIG, Fannie and Freddie Mac and a slew of other institutions — have created political risk in the form of moral hazard in the U.S. stock market.

Moral hazard is the nasty by-product of self-interest in capitalism. Rather than create wealth and drive innovation, the self-interest of market participants will drive them to take actions that are not in the better interests of the market and the economy.

Bailouts are a case in point. Poole said giving billions of dollars to failed financial institutions is driving investment into deficient business models.

Rewarding bad behaviour

“Bailouts are an affront to the market because they keep failed firms afloat and because they distort market risk assessment. Worse yet, firms deemed too big to fail attract even more capital simply because they are protected,” Poole said. “Today’s creditor risk assessment for any large bank is based entirely on whether the federal government will, in extremis, bail it out.”

Poole argues this is a good situation for creditors of banks; their money is essentially guaranteed. However, he says it creates serious potential pitfalls for equity investors of bailed-out firms.

“Creditors of big banks — who, after all, provide roughly 90% of a bank’s capital — have reason to believe, though not with absolute certainty, that their claims are safe. The efficiency of a big bank is essentially irrelevant to those who provide debt capital,” he says. “Providers of equity capital, on the other hand, are at considerable risk. The government might force a bank to raise new equity at a cheap price, substantially diluting existing shareholders. The risk assessment is not about a bank’s quality of management and soundness of its assets but about government policy.”

Of even greater concern to Poole is that the bailouts could have a longer-term impact on reinforcing bad management decisions and squeezing out smaller firms with more efficient business models.

Since the government will bail out institutions deemed too big to fail, banks are driven to achieve that status, often by taking on too much risk.

“The market will allocate too much capital to these firms,” Poole said. “Even in today’s risk-averse climate, some banks may be taking excessive risk as they are pressured by the federal government to expand lending to help us get out of the recession.”

Few regulatory solutions

Poole concedes that financial institutions such as AIG are an exception to business models. The consequence of letting a firm like AIG fail, which was the world’s largest guarantor of credit default swaps, would have devastating implications for the world’s financial system.

He argues that the bailout of AIG has to be considered an exception for bankruptcy intervention, not a precedent, as many market participants are viewing it. Poole suggests that government decision-making over public companies — which is driven by politics — can be at odds with what’s necessary to compete in a free-market system.

“If we treat AIG as a precedent, then we will face an endless number of decisions as to which firms must be bailed out, or seized by the government, because they are too big to fail,” he said. “There are no satisfactory criteria to determine which firms are too big to fail and which are too small to matter. Moreover, we will spread regulatory authority across the landscape, because if taxpayers are expected to bail out large firms, they will rightly demand a say in how these firms are operated.”

Poole says there is only one new regulatory alternative being proposed by politicians: to create a federal agency that would have the power to close down significant non-bank financial firms before they fail.

“The proposal stems from experience in dealing with AIG. Beyond this proposal, I’ve heard of no new regulatory ideas with any substance,” he said.

Poole did offer some policy ideas of his own. The most radical was for the U.S. government to consider removing interest deductibility in U.S. tax law. Poole believes this would create incentives for institutions to look to raising equity capital as opposed to debt capital.

“A quick look at 2005 data indicates that for the corporate sector as a whole, eliminating the deductibility of interest would roughly double corporate income subject to tax,” Poole said. “Given the current and prospective economic situation, the corporate profit tax would have to be cut further for revenue neutrality, perhaps to 10%.”

Poole also advocates that banks be required to have a large reserve of subordinated long-term debt on their balance sheets to offset their propensity to float short-term debt. This could stem from short-term liquidity crises that they have faced in the recent past.

Every bank, including savings institutions and investment banks, would be required to issue subordinated debt equal to 10% of its total liabilities, he said. The debt would be structured so that it would have to refinance one-tenth of its sub-debt every year, equal to 1% of its liabilities.

“The subordinated debt proposal has several important advantages. We have seen that banks do not have an adequate cushion against losses under current capital requirements. If taxpayers are to be expected to stand behind our giant banks, taxpayers deserve a larger cushion against bank mistakes,” he said. “More importantly, banks would have to go to the market every year to sell new debt and would have to convince the market they are safe.”

(05/05/09)