The Power of Inaction A volume in the series Cornell Studies in Political Economy edited by Peter J. Katzenstein A list of titles in this series is available at www.cornellpress.cornell.edu. The Power of Inaction Bank Bailouts in Comparison Cornelia Woll Cornell University Press Ithaca and London Copyright © 2014 by Cornell University All rights reserved. Except for brief quotations in a review, this book, or parts thereof, must not be reproduced in any form without permission in writing from the publisher. For information, address Cornell University Press, Sage House, 512 East State Street, Ithaca, New York 14850. First published 2014 by Cornell University Press Printed in the United States of America Library of Congress Cataloging-in-Publication Data Woll, Cornelia, author. The power of inaction: bank bailouts in comparison / Cornelia Woll. pages cm. — (Cornell studies in political economy) Includes bibliographical references and index. ISBN 978-0-8014-5235-2 (cloth: alk. paper) 1. Bank failures—Government policy. 2. Bailouts (Government policy) I. Title. HG1725.W654 2014 332.1—dc23 2013042835 Cornell University Press strives to use environmentally responsible suppliers and materials to the fullest extent possible in the publishing of its books. Such materials include vegetable-based, low-VOC inks and acid-free papers that are recycled, totally chlorine-free, or partly composed of nonwood fi bers. For further information, visit our website at www.cornellpress.cornell.edu. Cloth printing 10 9 8 7 6 5 4 3 2 1 To my family Contents List of Figures and Tables ix List of Abbreviations xi 1. Bailout Games 1 2. Crisis Management across the World 16 3. The Power of Collective Inaction 44 4. From Theory to Practice 65 5. The United States and the United Kingdom 82 6. France and Germany 112 7. Ireland and Denmark 139 8. Lessons Learned 165 Acknowledgments 177 Appendix: List of Interviews 181 Bibliography 183 Index 201 Figures and Tables Figures 1.1 Stock market activity versus bank credit 9 2.1 Real house prices, 2003–9 19 2.2 Committed and actual expenditures, 2007–10 32 2.3 Total expenditures 2008–10, (in € billion) 33 2.4 Instruments used as percentage of actual expenditures 36 5.1 FDIC resolution of banks 95 Tables 2.1 Net costs 2008–11 35 2.2 (Un)attractiveness of government support for participating institutions 38 2.3 Institutional setup of national schemes 41 2.4 Comparison summary 43 3.1 Experience of crisis management in 2008–9 60 3.2 Power relationship and actions by country 61 4.1 Approaches to bank accountability 80 8.1 The role of central banks 168 8.2 Overview of bank accountability 173 Abbreviations AFEP Association française des entreprises privées AIG American International Group BCCI Bank of Credit and Commerce International BdB Bundesverband deutscher Banken BVR Bundesverband der Volks- und Raiff eisenbanken CAP US Capital Assistance Program CBFSAI Central Bank and Financial Services Authority of Ireland CDS credit default swaps CEO chief executive offi cer CPP US Capital Purchase Plan DBA Danish Bankers Association DG Directorate-General DSGV Deutscher Sparkassen- und Giroverband EAA Erste Abwicklungsanstalt ECB European Central Bank EMU Economic and Monetary Union EU European Union Fannie Mae Federal National Mortgage Association FBF Fédération bancaire française FDIC Federal Deposit Insurance Corporation FDICIA Federal Deposit Insurance Corporate Improvement Act FHFA Federal Housing Finance Agency FMS-WM FMS Wertmanagement FMSA Bundesanstalt für Finanzmarktstabilisierung Freddie Mac Federal Home Loan Mortgage Corporation FSA Financial Services Authority FSCS Financial Services Compensation Scheme xii Abbreviations HBOS Halifax Bank of Scotland HRE Hypo Real Estate IFSC International Financial Service Centre IMF International Monetary Fund Indymac Independent National Mortgage Corporation KfW Kreditanstalt für Wiederaufbau LB Landesbank LikoBank Liquiditäts-Konsortialbank LTCM Long-Term Capital Management MEDEF Mouvement des entreprises de France NAMA National Asset Management Agency OeCAG Österreichische Clearingbank AG OIAG Österreichische Industrieholding AG PCAR Prudential Capital Assessment Review PwC PricewaterhouseCoopers SFEF Société de fi nancement de l’économie française SIGTARP Special Inspector General for the TARP SoFFin Sonderfonds Finanzmarktstabilisierung SPPE Société de prise de participation de l’Etat TARP Troubled Asset Relief Program UKFI United Kingdom Financial Investments 1 Bailout Games Nothing to be done. —Samuel Beckett, Waiting for Godot How could the US government let Lehman Brothers fail? Few ques- tions have been discussed as often in recent economic history, with as much fervor or bewilderment. Following the collapse of the investment bank on 15 September 2008, the fi nancial crisis that had built up for more than a year rippled through the global economy with breathtaking speed, destroy- ing $700 billion in value from retirement plans, government pension funds, and other investment portfolios in just one day, and over $11 trillion during the duration of the entire crisis. 1 Banks everywhere found themselves in great diffi culties as liquidity dried up completely, and the financial industry in many countries came to a near collapse. The picture was very similar in other countries with substantial fi nancial industries. To avoid repeating the experience of Lehman’s failure, governments rushed to stabilize their banking sectors through bailout schemes, most of them devised in the fall of 2008. This book compares these bank rescue schemes and makes a very simple point: it is impossible to understand government action without looking at the collective action of the fi nancial industry at the time of near collapse. Turning the opening question around, one needs to ask: How could the US fi nancial industry let Lehman Brothers fail? Clearly, US fi nancial institutions were all negatively aff ected by the bankruptcy of their competitor. The rationale for the public bank bail- outs that followed was precisely the systemic risk caused by the failure of individual fi rms. Presumably, the stability of the sector as a whole rather than the fi nancial health of these individual fi rms was what mattered for 1. Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, 339. 2 Chapter 1 the governments committing public money to save an ailing fi nancial in- stitution. Should the fi nancial industry not have been equally concerned about preserving this stability, which crucially aff ects the operations of all other fi rms? According to Federal Reserve Chairman Ben Bernanke, a scholar of the Great Depression, the pressure that was put on fi nancial fi rms in the aftermath of Lehman’s failure was the worst in history: “Out of the 13 most important fi nancial institutions in the United States, 12 were at risk of failure within a period of a week or two.” 2 Was it not in the interest of these institutions to avoid the shockwaves sent by Lehman Brothers’ bankruptcy? What might seem like a rather theoretical and scholarly question was in fact the question posed to the CEO’s of America’s major banks, gathered together by the US secretary of the treasury Henry Paulson on Friday eve- ning, 12 September 2008. Based on a proposal from the Federal Reserve Bank of New York, the administration asked the fi nancial industry to estab- lish a private sector liquidation consortium in order to facilitate an acquisi- tion, similar to the rescue engineered for the hedge fund Long Term Capital Management (LTCM) in 1998. As a contingency, they were asked to come up with an alternative, to fi nd another workable solution to deal with the ef- fects of Lehman’s failure. 3 Haunted by the criticism of the public guarantee provided for Bear Stearns several months earlier, the US government argued that it could no longer commit public funds for saving the fi nancial industry. “We did the last one,” Paulson told the bankers in the room, “you are doing this one.” 4 To push the fi nancial industry to fi nd a collective solution, he insisted that there would be no government support, “not a penny.” 5 The message from the US administration was met with incredulity. “We must be respon- sible for our own balance sheets and now we are responsible for others?” Lloyd Blankfein, CEO and chairman of Goldman Sachs asked. Paulson re- members how troublesome this realization was for businesses priding them- selves as free marketeers. “At what point were the interests of individual fi rms overridden by the needs of the many? It was the classic question of collective action.” 6 According to H. Rodgin Cohen, a Wall Street lawyer and Lehman’s legal counsel at the time, the “not a penny” posture was a politi- cal strategy. Indeed, the Fed’s internal liquidation consortium plan contem- plated a fi nancial commitment from the government that was not divulged. Cohen’s impression was that the government was “playing a game of chicken or poker.” 7 2. Cited in ibid., 345. 3. Baxter, Too Big to Fail , 3–4. 4. Cited in Wessel, In FED We Trust , 16. 5. Cited in Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report , 334. 6. Paulson, On the Brink , 198. 7. Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report , 334. Bailout Games 3 A giant and collective game of chicken, indeed! Like the car game that became a household example in game theory, both parties appeared to be driving at full speed at each other in a single lane that crosses a bridge. In such games, where both acknowledge that the worst possible outcome is a crash—the collapse of the economy—the one who yields fi rst, loses. If the government saves Lehman Brothers, it will commit important amounts of taxpayer money and create substantial moral hazard, which may lead to fur- ther rescues becoming necessary in the future. If the industry saves Lehman Brothers’, it will have to collectively carry the costs, at a time where almost all of them had considerable diffi culties themselves.