A Framework for Bailout Regulation

Notre Dame Law Review Volume 91 | Issue 2 Article 1 2-2016 A Framework for Bailout Regulation Anthony J. Casey University of Chicago Law School Eric A. Posner University of Chicago Law School Follow this and additional works at: http://scholarship.law.nd.edu/ndlr Part of the Banking and Finance Law Commons Recommended Citation Anthony J. Casey & Eric A. Posner, A Framework for Bailout Regulation, 91 Notre Dame L. Rev. (). Available at: http://scholarship.law.nd.edu/ndlr/vol91/iss2/1 This Article is brought to you for free and open access by the Notre Dame Law Review at NDLScholarship. It has been accepted for inclusion in Notre Dame Law Review by an authorized administrator of NDLScholarship. For more information, please contact . \\jciprod01\productn\N\NDL\91-2\ndl201.txt unknown Seq: 1 1-FEB-16 7:57 ARTICLES A FRAMEWORK FOR BAILOUT REGULATION Anthony J. Casey & Eric A. Posner* 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 © 2016 Anthony J. Casey & Eric A. Posner. Individuals and nonprofit institutions may reproduce and distribute copies of this Article in any format at or below cost, for educational purposes, so long as each copy identifies the author, provides a citation to the Notre Dame Law Review, and includes this provision in the copyright notice. * University of Chicago Law School. We thank Stephen Choi, Kate Judge, William Hubbard, Richard McAdams, Eric Rasmusen, Michael Simkovic, David Yermack, and participants in workshops at NYU Stern School of Business and the University of Chicago Law School and at the Canadian Law and Economics Association Annual Meeting for comments, and Paul Rogerson and Paulina Wu for research assistance. The Weil Faculty Research Fund provided generous support. Although we do not take a position on AIG’s claims in its bailout-related litigation, we should disclose that one of us (Posner) has done work in that litigation for the plaintiff. He is grateful to the late Robert Silver for illuminating discussions about bailout law and policy in the context of that litigation. 1 Sheryl Gay Stolberg, Constituents Make Their Bailout Views Known, N.Y. TIMES (Sept. 24, 2008), http://www.nytimes.com/2008/09/25/business/25voices.html?_r=0 (“Senator Barbara Boxer, Democrat of California, has received nearly 17,000 e-mail messages, nearly all opposed to the bailout, her office said.”). 479 \\jciprod01\productn\N\NDL\91-2\ndl201.txt 480 unknown Seq: 2 notre dame law review 1-FEB-16 7:57 [vol. 91:2 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.4 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, dairy 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 2 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified as amended in 12 U.S.C. §§ 5301–5641). 3 Remarks on Signing of Dodd-Frank Wall Street Reform and Consumer Protection Act, 2 PUB. PAPERS 1087, 1089 (July 21, 2010), http://www.gpo.gov/fdsys/pkg/PPP-2010book2/pdf/PPP-2010-book2.pdf. 4 REPUBLICAN STAFF OF H.R. COMM. ON FINANCIAL SERVS., FAILING TO END “TOO BIG TO FAIL”: AN ASSESSMENT OF THE DODD-FRANK ACT FOUR YEARS LATER (2014), http://financialservices.house.gov/uploadedfiles/071814_tbtf_report_final.pdf. 5 See infra Part I. 6 12 U.S.C. § 1821(a)(1)(E) (2012). \\jciprod01\productn\N\NDL\91-2\ndl201.txt 2015] unknown Seq: 3 a framework for bailout regulation 1-FEB-16 7:57 481 other benefits that make it easier for them to pay off their debts while (...truncated)