Chapters 28.7-28.8: Money, banking, financial institutions   

The Policy Response to the Financial Crisis

The Treasury Bailout: TARP

  • In late 2008, Congress passed the Troubled Asset Relief Program (TARP)   * allocated $700 billion to the U.S. Treasury to make emergency loans to critical financial and other U.S. firms   * major recipients: AIG, Citibank, Bank of America, JPMorgan Chase, and Goldman Sachs
  • TARP saved financial institutions whose bankruptcy would’ve brought down other financial firms and frozen credit throughout the economy   * demonstrated moral hazard
  • moral hazard::   * the tendency for financial investors and financial services firms to take on greater risks because they assume they are at least partially insured against losses
  • large firms assumed they were simply too big for government to let them fail which gave them the incentive to make riskier investments

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The Fed’s Lender-of-Last-Resort Activities

  • Under Fed Chair Ben Bernanke, the Fed designed and implemented new lender-of-last-resort facilities to pump liquidity into the financial system   * this was in addition to both the TARP efforts by the U.S. Treasury and the Fed’s use of standard tools of monetary policy designed to reduce interest rates.   * All the new Fed facilities had the single purpose and desired outcome of keeping credit flowing.
  • the Fed bought securities from financial institutions   * The purpose was to ^^increase liquidity in the financial system^^ by exchanging illiquid bonds (that the firms could not easily sell during the crisis) for cash, the most liquid of all assets   * Total Fed assets rose from $885 billion in February 2008 to $1,903 billion in March 2009
  • Many economists believe that TARP and the Fed’s actions helped to avert a second Great Depression.
  • But they also ^^intensified the moral hazard problem^^ by limiting the losses that would have resulted from bad financial assumptions and decisions

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The Postcrisis U.S. Financial Services Industry

  • the main categories of the financial services industry are   * commercial banks   * thrifts   * insurance companies   * mutual fund companies   * pension funds   * security firms   * investment banks
  • financial services industry::   * The broad category of firms that provide financial products and services to help households and businesses earn interest, receive dividends, obtain capital gains, insure against losses, and plan for retirement.
  • before the financial crisis of 2007–2008, the financial services industry was consolidating into fewer, larger firms, each offering a wider spectrum of services.   * In 1999, Congress ended the Depression-era prohibition against banks selling stocks, bonds, and mutual funds.

 

  • even when institutions take on services in more than 1 category, the main lines of a firm’s businesses often are in one category or another   * ex. even though Goldman Sachs is licensed and regulated as a bank, it is first and foremost an investment company
  • In mid-2010 Congress passed and the president signed the Wall Street Reform and Consumer Protection Act which included:   * Eliminate the Office of Thrift Supervision and give broader authority to the Federal Reserve to regulate all large financial institutions.   * Create a Financial Stability Oversight Council to be on the lookout for risks to the financial system.   * Establish a process for the federal government to liquidate (sell off) the assets of failing nonbank financial institutions, much like the FDIC does with failing banks.   * Provide federal regulatory oversight of mortgage-backed securities and other derivatives and require that they be traded on public exchanges.   * Require companies selling asset-backed securities to retain a portion of those securities so the sellers share part of the risk.   * Establish a stronger consumer financial protection role for the Fed through creation of the Bureau of Consumer Financial Protection.
  • Proponents of the law say that it will help prevent many of the practices that led up to the financial crisis of 2007–2008   * sends a warning to stockholders, bondholders, and executives of large financial firms that they’ll suffer high losses if they get into financial trouble again
  • Skeptics of the law say that regulators already had all the tools they needed to prevent the financial crisis.   * government’s own efforts to promote home ownership, via quasi-government institutions that purchased mortgage-backed securities, greatly contributed to the financial crisis
  • Critics of the law say that it will simply impose heavy new regulatory costs on the financial industry while doing little to prevent future government bailouts

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