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Lobbying Creates Moral Hazards for Banks

Since George W. Bush took office, commercial banks have more than doubled their annual federal lobbying budgets, to great effect. In addition to securing a nearly industry-wide bailout in the wake of a financial crisis spurred by their own risky investments, banking lobbyists notched many successes in scaling back the consumer protection agency. From Reuters:

The lobbyists have successfully scaled back various iterations of the plan. One would make the regulator part of the Treasury Department, and force it to consult with existing watchdogs before imposing restrictions. Republican alternatives are even weaker, alternately housing a consumer unit either in the Federal Deposit Insurance Corp or the Federal Reserve. Expect a diluted compromise between diluted compromises — just as seems the case for the “Volcker Rule” to limit proprietary trading by banks.

But perhaps the most dangerous effect all this lobbying has had is on banks’ own behavior.

From the beginning, economists warned about the potential for a bank bailout to create moral hazard. Moral hazard is a market failure in which companies, like banks, take bigger risks than they would with their own money because they know they have a backup plan — like a government bailout. For decades, the same voices had warned that Fannie Mae and Freddie Mac, though technically private enterprises, carried a moral hazard because their management and their investors expected that the government would bail them out if their risks turned out poorly and, in fact, when their risky investments tanked, the government did exactly that instead of allowing them to fail.

Neil Barofsky, the Special Inspector General for the Troubled Asset Relief Program — the banking bailout — has said for months that the bailout has inculcated the same moral hazard in regular banks that government involvement in Fannie Mae and Freddie Mac did for them. In his most recent report, he identified the moral hazard as one of the largest costs of the TARP program, and one against which the government needed to better guard.

To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.

Barofsky refers to the fact that many companies exited the TARP program by the end of 2009 in order to avoid caps on executive compensation, and yet some banks continue to operate at a loss — the very thing their participation in TARP was intended to avoid. Since the banks that exited the TARP program have another 20 months to fail and re-enter the program, they can engage in overly risky behavior knowing that they continue to have a government safety net.

Pethokoukis notes that a recent IMF report shows that lobbying also produces behavior in line with banks operating under a moral hazard.

The International Monetary Fund recently found that banks that invested more to influence policy over the past decade were more likely to take more securitization risks, have larger loan defaults and sharper stock falls during key points of the crisis.

In other words, banks that spent millions of dollars to change policies, reduce or eliminate regulation and lobby for bailouts engaged in riskier behaviors — including many of those behaviors that led to the financial crisis — than those banks that didn’t feel they needed to invest in changing the structure of the market in which they operated. Spending money on lobbyists to change the rules of the game, so to speak, seemingly leads companies to behave as though they can mitigate or eliminate market risks by convincing government officials to change the regulatory environment or simply front the cash to avoid failure. Thus, lobbying and bailouts become a constant cycle of moral hazard, reinforcing perceptions in the market that a bank’s risk isn’t really of failure or financial loss, but of having to spend more money to lobby the government to fix things.

Last year, commercial banks alone spent $50 million lobbying Congress, not to mention the money they donated, through PACs and individual donations, to candidates. Some of the money they spent lobbying to change the rules and eliminate regulation came straight from taxpayers’ pockets in the form of TARP funds. So Americans’ hard-earned money didn’t just go to pay executives multi-million salaries; it also went to lobby the government to maintain conditions that will allow the banks to reap huge profits and take great risks, and then rely on the government to bail them out if they fail again.

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