Bright Lines and Bailouts: To Bail or Not To Bail, That Is the Question

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A financial-institution bailout involves governmentintervention through a transaction or forbearancetargeted to a financial institution orgroup of financial institutions. The action is preemptiveas the financial institution does not failand go out of business, but remains a going concern,benefiting creditors, shareholders, or counterparties.In the absence of a bailout, the financialinstitution would either be forced to go throughreceivership or bankruptcy in the prescribed legalform, or have its role in financial intermediationdisrupted.

Financial-institution bailout policy in theUnited States is implemented through three agencies:the Federal Deposit Insurance Corporation,the Federal Reserve, and the Treasury Department.The need for orderly financial dealings, particularlyin times of crisis, would dictate a consistentapproach by these agencies based on cumulativeexperience, ensuring that officials devote publicresources only where there is a well-defined, transparent,and verifiable policy justification for abailout. Yet the bailouts over the past year do notreflect a well-defined, transparent, and verifiablepolicy justification. Even in the cases where a standardhas been articulated, the agencies have notdemonstrated that they can successfully implementthat standard in practice.

Beyond the inconsistencies and implementationproblems, financial-institution bailout policyhas been unwieldy, inequitable, extremely costly,disruptive, and lacking in transparency and oversight.The policy response of bailouts and maintenanceof the status quo has been precisely thewrong response, as it has led to retaining many ofthe mega-financial institutions that pose systemicrisk, thus planting the seeds for future crises.

This present crisis has demonstrated that undertakingbailouts of troubled institutions, whichinvolves structuring transactions that attempt totransform the institution into a viable one, whilesimultaneously projecting the reaction of investorsand markets, is a process for which government is ill-suited.These bailout powers should be revoked.Financial angst still hangs over the system as theunderlying imbalances that led to the crisis have notbeen reconciled. The ultimate answer is to placetroubled institutions into receivership or the relevantform of bankruptcy—including many of theinstitutions that have already been bailed out.

Vern McKinley and Gary Gegenheimer

Vern McKinley worked at the Federal Deposit Insurance Corporation in the 1980s during the banking crisis in Texas and at the Resolution Trust Corporation in the 1990s as it resolved hundreds of insolvent savings and loans. He currently advises central banks and deposit insurers worldwide on legal and policy issues. Gary Gegenheimer was an attorney with the Office of Thrift Supervision and its predecessor agency, the Federal Home Loan Bank Board, during the savings and loan crisis of the 1980s and early 1990s. Currently he is a senior legal adviser with BearingPoint, Inc., in McLean, Virginia, and has provided legal assistance to central banks and bank supervisory authorities in emerging market countries since 1995.