Introduction
As a young economics student, I once asked one of my professors, “Should markets or the government run the economy?” I still remember the puzzled look on my professor’s face as he considered the question. A moment later he answered my question with a question. He asked, “Do you like driving cars?” I quickly nodded my head and he then followed up with, “Well then, do you think the car’s engine should be run by its pistons or its spark plugs?” His point was simple, but important. A car’s (gasoline) engine can’t run without both its pistons or sparkplugs. Having a preference for one over the other simply makes no sense. Similarly, large banks, and all private enterprises, coexist alongside government in our economy. And our modern economy can’t operate productively or efficiently without contributions from both. In this post, we discuss the ways in which large banks and government policy work together to support a strong, stable and growing economy.
Implicit Government Support for Large U.S. Banks Is No Longer Prevalent
A lot has changed in our economy over the past twenty years. In the case of the banking sector, large banks have undergone a number of significant changes to improve their overall safety through stronger capital and liquidity as well as improvements to their corporate structure, risk management, and governance. In addition, regulators have new tools that they can use to address a large bank that is in trouble. As a result of these significant changes, market perceptions that the government implicitly supports or subsidizes large banks have waned.
And this observation is backed by data and research. In 2014, the Government Accountability Office (GAO) published a report that examined whether market participants expected government support for large banks. The findings of the GAO report showed that the evidence in favor of implicit government support for large U.S. banks had significantly declined by 2014. Specifically, the report found that “recent regulatory reforms have reduced but not eliminated the likelihood that the federal government would prevent the failure of one of the largest bank holding companies.” Since 2014, the evidence in this regard has only strengthened. In “The Decline of Too Big To Fail,” economists at Stanford University and the Australian National University recently found, in 2021, even stronger evidence of a lack of expected government support for large U.S banks. They conclude that, “[t]he data are consistent with measurable effectiveness for the official sector’s post-Lehman GSIB [large bank] failure-resolution intentions, laws, and rules. GSIB [large bank] creditors now appear to expect to suffer much larger losses in the event that a GSIB [large bank] approaches insolvency. In this sense, we estimate a major decline of “too big to fail.”
The Positive Feedback Loop Between Government Support and Large Banks
The fact that large banks do not benefit from implicit government support, however, does not mean that large banks do not benefit from government policy. Large banks, like all businesses and households, benefit from all sorts of government policies. Some policies are narrowly targeted at banks, such as deposit insurance or access to the Federal Reserve’s discount window. Other policies reflect broader government policy that is aimed at supporting the whole economy, such as macroeconomic stabilization policy. Consider the recent government efforts to stabilize the economy during the pandemic. Many of these policies, such as stimulus checks and enhanced unemployment benefits, have been crucial to supporting the economy during the pandemic. And large banks, like all industries and households, have benefitted from a stabilized economy. Effective stabilization policy reduces the severity of macroeconomic cycles and improves outcomes for everyone. Also, and importantly, government policy that supports the economy also helps large banks to continue supporting the economy, which further enhances the effectiveness of government policy. This complementarity between government policy and the contribution of large banks results in a “positive feedback loop” that benefits the whole economy. As the economy improves, large banks are able to further support the economy through lending and financial intermediation, which leads to a further strengthening of the economy. Accordingly, government policy and the activities of large banks work in tandem to support our economy.
Large Banks Have Been a Conduit for Pandemic Government Polices
The onset of the pandemic witnessed an aggressive government policy response to curb its fallout. A number of policies were enacted that operated through large banks. Examples of such policies would include the government’s Paycheck Protection Program, facilities that were erected by the Federal Reserve to support the financial system such as the Primary Dealer Credit Facility and the Money Market Liquidity Facility, as well as limited duration, and targeted modifications to certain regulations, such as the now-expired exclusion of bank reserves and U.S. Treasuries from the supplementary leverage ratio. In each of these cases, the government’s stated policy objective was to support households and businesses. Large banks participated in these programs as a conduit to channel credit and liquidity into the economy. To analogize, after a hurricane, local governments often hire construction companies to rebuild homes and schools. This rebuilding is necessary to revitalize a battered community and bring it back to life. In the same way, the government’s pandemic policies have buoyed our economy at a time of great need and large banks have been a constructive and important part of that effort.
Conclusion
Across the entire economy all industries work in tandem with government policy to realize the maximum potential of our economy. Large banks are no different from other industries that benefit from all sorts of government policy. The important point is that this partnership between government and industry is an important part of ensuring that the whole economy operates as productively and efficiently as possible. Going forward, large banks will continue to work constructively with the government to realize the maximum potential of our economy.