The Financial Crisis and the Rule of Law

Close political ties between Wall Street and the government played a sizeable role in creating a regulatory environment in which financial institutions became dangerously over-exposed to risk. In a democracy where campaign contributions are vital to lawmakers’ chances of getting elected, we cannot be astonished when the biggest and richest industries get the most effective representation in Washington. Nor should we be surprised when handsomely paid advocates of those industries routinely outwit modestly paid civil servants in regulatory proceedings and the courtroom. Some of the most able lawmakers and public officials consider it plausible they will someday find themselves working -- with a suitable 6- or 7-digit salary -- for the very firms they now regulate. This undoubtedly colors their views of the appropriate degree of zeal that should be applied to the task of regulation.

Wall Street firms whose behavior helped created the world-wide crisis are now working diligently to prevent regulatory changes that can help restore the financial system to long-term health. While bankers may gladly accept government aid if it will bring their institutions back into the black, many will unhesitatingly oppose steps that have been applied in other financial crises to bring economies back to life. M.I.T. economist Simon Johnson has no doubt about the government’s proper course of action. It is to “… nationalize troubled banks and break them up as necessary.” He is also frank in acknowledging the price tag -- $1.5 trillion, or 10 percent of U.S. GDP. This is only step #1, however. Johnson’s second recommendation is to break the economic and political power of America’s financial “oligarchs.” In a future economic recovery, financial institutions cannot be allowed to take on risks that endanger the broader economy. Johnson rightly worries that financial institutions are now using their political influence to prevent or minimize the reforms that would make future crises less likely.

Before proceeding to step #2, however, we should consider carefully whether our laws make it possible to take step #1. A number of observers, including Johnson, are confident that a number of major banks require immediate nationalization. I’m less certain that nationalization is legally or politically feasible. The Fifth Amendment protects U.S. residents against uncompensated government seizure of their property: “… nor shall any person be … deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.” This implies that for nationalization to occur legally the government must either satisfy itself a bank is insolvent or provide just compensation to the bank’s owners. As my colleague Douglas Elliott points out, demonstrating bank insolvency will not be easy and providing compensation to a bank’s owners will not be cheap (“Bank Nationalization: What Is It? Should We Do It?” and “Preemptive Bank Nationalization Would Present Thorny Problems”).

Wall Street’s critics might be correct. A sober appraisal of bank assets could show that several big banks do not meet reasonable tests for liquidity or capital adequacy. However, the government must develop good evidence that this is true if it does not want to set off panic in solvent banks and among investors who own bank stocks and bonds. The regulations covering banks are complicated. At the beginning of this year it appeared that the major banks were liquid and had adequate capital to satisfy their minimum capital requirements. Congress could of course change the laws under which capital adequacy is judged. However, the takings clause of the Fifth Amendment means the government may have to compensate bank equity and bondholders if courts someday decide nationalization represented an impermissible taking. In resolving the savings and loan crisis in the late 1980s, Congress took decisive action to redefine how S&L assets should be valued for purposes of assessing an institution’s solvency. This redefinition weakened the balance sheets of many S&Ls considered healthy under the pre-reform valuation rules. Aggrieved S&L owners sued the government for damages. Federal courts ultimately sided with S&L owners and required the government to pay substantial compensation to owners for the losses they sustained when the rules were changed.

The alternative to involuntary seizure is for the government to buy a bank from its current owners. However, as Douglas Elliott reminds us this is likely to prove costly. If the transaction is voluntary, equity owners will demand a premium over the current market price of their shares. Bank bondholders will see an appreciation in the value of their bonds, because the government can be expected to pay 100 cents on the dollar for future principal and interest payments. In light of the current unpopularity of banks and bankers, it is hard to imagine Congress appropriating huge sums that would directly enrich bank officers, stock owners, and bondholders in such an obvious way. In sum, cheap nationalization of banks is probably illegal and voluntary nationalization of these institutions may be prohibitively expensive. More to the point, in the current environment voluntary nationalization is politically infeasible.

The plain fact is that bank nationalization requires political will and a lot of money. Until the Administration’s critics can show us the money, the nation may have to wait for a couple of big banks to fail before bank nationalization becomes a live possibility.