Last week, the Treasury Department announced a new approach to
addressing the crisis gripping financial markets: the direct
purchase of equity stakes in U.S. banks in order to increase the
capital levels of those institutions.
While it is a potentially effective step toward rebuilding
confidence in the banking system and restarting the credit
markets, the action is also a dangerous one.
Policymakers must ensure that the result is not a legacy of
political control of the financial system, threatening the
efficiency of markets and the principle of private ownership.
Under normal circumstances, the very concept of direct
government purchase of bank stock of any type would be unthinkable
and unacceptable. That is no doubt one reason the Treasury
initially contemplated only the purchase of troubled, non-equity
assets for its Troubled Assets Relief Program (TARP). But the
persisting and severe disruption in financial markets led
policymakers to take stronger action.
Moreover, to a large extent, the hand of U.S. policymakers was
forced by overseas governments that provided similar capital
programs to their banks. If the U.S. government had not established
this program, foreign banks would have been seen as safer, and ours
would have been at a disadvantage. Subsequently, large depositors
and investors would have moved their money to the foreign
However, the U.S. should not allow international pressure to
determine its financial regulatory policy. The U.S. government's
responsibility is to develop and implement policies that are in our
national interest, not to make those interests second to
international opinion. While it is reasonable for governments to
consult during an international financial crisis, no government
should be expected to take actions that put its own citizens'
interests at a disadvantage.
The program sparked a generally positive reaction in financial
markets and appears so far to be effective. But as a matter of
principle, the government should not be allowed to control or
unduly influence the management decisions of private banks through
partial ownership in them. A banking system free from such
government control is an essential part of a free market
In order to minimize this danger, policymakers should stake out
clear boundaries for the bank capital system that must not be
- It Must Be Temporary. The program must not lead to
either a permanent government ownership stake in financial
institutions or government meddling into banks' business decisions.
The overall program must have a definite and reasonable termination
date, and any restrictions imposed upon banks or their management
should end with the program.
- There Must Be No Attempt to Allocate Credit.
Interference in credit allocation or other business activities must
be avoided. The government's role must not extend to bank lending
policies (e.g., lending criteria, specific loan decisions, or
decisions as to lending amounts). Press reports indicate the
federal government plans to--at least indirectly--extend its
influence inappropriately into these areas. Financial institutions
should seek ironclad assurances that this is not the case before
they agree to participate.
- Any Government Investments Should Include Only Nonvoting
Preferred Stock. Any government ownership stake must include
only nonvoting preferred stock--stock that does not allow the
holder a stockholder vote--and not any form of common voting
shares. No government representatives should be placed on a bank's
board of directors. The program currently meets these
- It Must Be Voluntary. Participation in the program by
individual banks must be fully voluntary, and banks that
participate should be able to repay government investments at their
discretion at any time. However, if a bank does not join and then
subsequently fails, management should be liable for at least some
of the costs of its resolution. Press reports indicate that while
no bank has been formally required to participate, substantial
government pressure was applied to induce them to do so. Similar
pressure may have been applied to other banks. Such government
coercion is inconsistent with what should be a voluntary program
and sets a very troubling precedent.
- Any Restrictions on Executive Pay Must Be Strictly
Limited. Modest restrictions on dividend payment make sense to
protect the taxpayers' investment, but limits on executive pay,
bonuses, and termination benefits encroach on the principle that
government should have no role in the management of these private
firms. Thus such limitations are appropriate only if participation
in the program is truly voluntary and only if the limitations
themselves are temporary and limited and have a definite expiration
- Taxpayers Should Share in Any Profits. It is appropriate
as a condition of participation that banks accepting taxpayer money
should provide the program with warrants for future stock purchases
that can be sold to private investors to reduce the long-term costs
of the program.
Because the recent turmoil in the financial system threatens the
operation of the credit markets and could seriously damage the
economy, solutions that would be anathema at other times may be
justified. The financial situation remains serious, and further
steps may be necessary. As a result, policy makers should give the
Treasury Department and the financial regulators the flexibility
necessary to act.
However, those actions must be carefully controlled and limited
in both time and scope so as to preserve over the course of this
situation the free market principles and independent institutions
that are necessary for America's economic health.
David C. John is Senior
Research Fellow in Retirement Security and Financial Institutions
in the Thomas A. Roe Institute for Economic Policy Studies at The
bank capital purchase program was one of many programs that were
announced by Treasury last week. FDIC's temporary deposit insurance
coverage of all amounts held in non-interest-bearing transaction
accounts and its temporary guarantee of bank debt are both
appropriate responses to the current financial turmoil. Similarly,
the Federal Reserve's temporary commercial paper funding facility
is an important step toward restarting the credit markets.