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How the Government Has Made the Banks Into Gamblers

PH2009050700657.jpgThe New Republic's Noam Scheiber offers two reasons the prospect of banks straining to repay their Troubled Assets Relief Program money worries him. They worry me too, and for the same reasons.

The only thing I'd add is that this is a risk-free proposition for the banks. Imagine a card player at a casino. He's made some bad bets. Bad, big bets. He's run down the family's savings. He doesn't have enough to pay the mortgage. He's down to his final thousands. And he can't face his wife having lost this much money. So he has two choices: The first is to make big bets in the hope of winning everything back. The second is to go home, face the consequences, and slowly make his money back.

Now imagine the casino owner won't let him fail. Can't let him fail. Maybe he knows the guy's father. Maybe he owes him a favor. Whatever. If the gambler goes bust, he just gets more chips. The incentive, suddenly, is to make big bets. To try and pull out a miracle.

This is why the government needs to develop a credible process for allowing and managing a bank's failure. Right now, the banks are like that gambler. They've lost just about everything. But since the government won't let them actually lose everything, they have an incentive to make big bets. To repay the TARP too early and try and trick the market into thinking them healthy. The only thing they have left to fear is failure. But we've taken failure off the table. So what do they have left to fear?

The banks know we won't let them fail. We can't let them fail. Tim Geithner doesn't even have the authority to unwind them if they fail. Repaying their TARP money early is thus a low-risk proposition. High upside in that they look healthier to investors. Low downside in that they're still protected by the federal government.

Related: Simon Johnson has some further thoughts on the problem of insolvency in banks that can't fail.

(Photo credit: AP Photo/Nell Redmond)

By Ezra Klein  |  May 21, 2009; 9:03 AM ET
Categories:  Financial Crisis  
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Sure, but we've made the decision to recapitalize them rather than let them fail. That was where the moral hazard was. Once that decision was made, the method of recapitalization -- that's a different question.

Posted by: gfkw917 | May 21, 2009 11:45 AM | Report abuse

But we made that decision in part because we couldn't, at that point, let them fail. Both because the system was unstable and we weren't prepared for it. But even if recaitalization is preferable, that's no reason not to have a clear process for failure in the bank room. If a bank opts out of recap by paying back TARP and the becomes insolvent, it should know that failure is an option!

Posted by: Ezra Klein | May 21, 2009 11:51 AM | Report abuse

It would help if Ezra didn't quote one of the most wrong voices in this crisis, Simon Johnson.

It would also help if Ezra knew that the TARP money doesn't even count in the Government's calcuation of Tier 1 common capital, therefore it is providing no benefit at all to the banks. These are all basic, and I truly mean basic points.

Posted by: kovachs | May 21, 2009 1:47 PM | Report abuse

What I loathe about the discussion of all the regulatory failures needed to create a crisis of this magnitude is that it overlooks the input of the banker.

Bankers make millions in compensation and are, for the most part, educated at the finest institutions of higher learning in the world. (Just what benefits, exactly, has the Harvard MBA program brought to the financial community?!)

No one forced the "best and brightest" to turn the housing market into a high stakes craps game. They did that to themselves.

That the US Treasury (US taxpayer) now must act as a helicopter parent to rescue these highly compensated executives is pathetic.

But the bankers are in this pickle precisely because they're gamblers, not because the feds made them that way.

Posted by: anne3 | May 21, 2009 3:47 PM | Report abuse

This is a good metaphor, which is why I am making a test post right here.

Posted by: albamus | May 21, 2009 5:30 PM | Report abuse

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