Outlawing Bailouts Won't End Them

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The U.S. Federal Reserve has adopted a rule that illustrates a fundamental contradiction in Congress's approach to financial reform: Legislators want to outlaw bailouts, but neither they nor regulators have done enough to make bailouts unnecessary.

The rule, mandated by the Dodd-Frank Act of 2010, prevents the Fed from providing emergency loans to individual institutions. It says any such program must apply to at least five entities, and loans must be made at a penalty rate. The rule forbids the kind of targeted support that was offered to Bear Stearns and AIG during the 2008 crisis.

The goal is worthy. Companies should bear responsibility for their actions, not stick taxpayers with the bill. The expectation of government support skews incentives, weakens market discipline and encourages the kind of irresponsible lending that leads to crises.

That said, curbing the Fed's emergency powers won't by itself end the need for bailouts. Dodd-Frank offers a substitute -- the orderly liquidation authority, which purportedly allows regulators to salvage troubled institutions without tapping taxpayer funds -- but it's untested. Even with the best system in place, unforeseen events could require the kind of fast, flexible response that only an independent central bank can provide. For all its faults, the rescue of AIG in 2008 averted a much worse outcome.

QuickTake Capital Requirements

Limiting the Fed's freedom of action makes it all the more vital to reduce the likelihood of such emergencies. The best way is more equity capital -- financing provided by investors who share in a company's profits and losses. Current rules require the largest U.S. banks to have only $5 in equity for each $100 in assets, enough to absorb only a 5 percent net loss. Research and experience suggest that sharply increasing capital requirements would benefit the economy by enhancing banks' capacity to take risks. Legislation aimed at doing so has gone nowhere.

Taxpayers aren’t the only ones threatened when financial institutions burn through their equity: Despite the Fed's and the government's best efforts, the 2008 crisis did lasting damage that millions of unemployed and underemployed workers are still feeling. Instead of making bailouts illegal, the right response would be to make the system more resilient in the first place.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.