Opinion: Bringing Shadow Banks Into the Light

(April 22) -- With the seemingly endless congressional battle over health care reform finally concluded, the Obama administration has turned its sights this month on reforming the regulations that govern Wall Street and that failed us so massively during 2007 and 2008.

The subject is a complicated one (something the banks are eager to take advantage of), and the bill drafted by Sen. Chris Dodd, D-Conn., is equally complicated. But the overall point is really quite simple: The massive bailouts undertaken in the fall of 2008 are unacceptable and reforms must be implemented to make sure they never happen again.

It's a goal that should be uncontroversial. And, indeed, it's so uncontroversial that when conservative pollster Frank Luntz was giving Republicans advice about how to beat regulatory reform he basically just told them to say the reforms will lead to bailouts. It's a line that's been duly echoed by House Minority Leader John Boehner, R-Ohio, and Senate Minority Leader Mitch McConnell, R-Ky. -- rhetoric deemed "false" by PolitiFact and even contradicted by Republican senators such as Bob Corker, R-Tenn., and Judd Gregg, R-N.H.

To understand why McConnell's wrong, you need to understand why bailouts happened in the first place. And to understand that, you need to understand bank runs, which were common in the United States until the 1930s.

A bank run happens when too many people try to withdraw their cash simultaneously. The way a bank's business works is that it promises all depositors that they can get their money at any time, while assuming that in practice only a small proportion of the funds will be withdrawn on any given day, and it loans out most of the money.

But if the bank makes a bunch of bad loans, it could run out of money and not be able to repay its depositors. Worse, if one bank goes bust, depositors at other banks may rush to take their money out. When too many people try to do this at once, that itself makes the bank fail, no matter how solid its lending was. Then once that happens, people everywhere start to panic.

The response from the Roosevelt administration was the Federal Deposit Insurance Corp., which insures deposits but doesn't "bail out" failed banks. When a bank goes into FDIC receivership, the owners lose everything and the management generally gets fired, but depositors are guaranteed their money back, up to a federally established limit.

This reform prevents bank runs, helps the economy and minimizes moral hazard. It does cost some money, but the funds are raised through fees on the insured banks. The problem is that the laws creating this system are more than 70 years old, and, in the intervening decades, a "shadow banking system" of banklike activities arose outside the FDIC umbrella.

Its participants wanted to evade regulatory scrutiny, so they simply promised that they'd never find themselves asking for bailouts. But when troubles arose, it turned out shadow banks were as vulnerable to runs as real banks.

And if runs had been allowed to happen, it would have spelled big trouble -- and not just for banks. A large company can't park its cash in the same kind of checking account you or I might use, and most of those kinds of funds are tied in to shadow banking. Runs would have made it hard to meet payroll or other basic financial obligations, shutting the economy down. And the only way to prevent runs was through quick-and-dirty bailouts -- gifts of cash with the implicit promise of more gifts.

The key to Obama's regulatory reform proposals is to do away with this system and give the government "resolution authority" over all forms of modern-day financial institutions.

This is not a bailout. It's more like an organized execution -- management will be sacked, owners will lose their money -- but it will still cost money to carry out, money that will be gained through fees on banks.

This will make the overall system more stable, but it will also mean that regulators will have to watch shadow banks more closely.

That, of course, isn't what bankers want. Their dream scenario is for Congress to just promise really, really, really hard that it'll never do a bailout again. Then the banks go unregulated, and when the next crisis comes the bailouts will come nonetheless.

Matthew Yglesias is a fellow at the Center for American Progress Action Fund. He has previously worked as an associate editor at The Atlantic, a staff writer at The American Prospect, and an associate editor at Talking Points Memo. His first book, "Heads in the Sand," was published in 2008. He blogs at Think Progress.


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