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60% of Financial Sector Has Government Backing: Richmond Fed

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If your debt payments grow to be significantly greater than your cash flow and credit capacity, you’re probably heading to bankruptcy, unless you’re lucky enough to have some rich uncle who can bail you out.

But if you’re a U.S. financial institution, no worries — you’ve got a rich uncle, Uncle Sam, whose commitment to bail you out has grown by the trillions over the past decade and a half.

An updated reckoning of the safety net the U.S. government provides the financial system, calculated by the Federal Reserve Bank of Richmond, shows that explicit and implicit government guarantees have grown to cover 60% of financial sector liabilities — up from about 45% in 1999.

What the Richmond Fed calls its “Bailout Barometer” has now reached $26 trillion.

Before the potential liability causes an aneurysm, consider the “good news” that taxpayers will never be on the hook for this for a number of reasons, starting with the fact that the U.S. lacks the financial means for a bailout of this size.

As the Richmond Fed points out, last year’s GDP totaled less than $17 trillion. Moreover, the government — one hopes — is unlikely to have to bail out the financial system in its entirety, and even those firms that come to trouble have some assets that can be deployed to offset some of their liabilities.

Rather, the concern animating the Richmond Fed’s bailout barometer project is that government guarantees, be they explicit or implicit, encourage risk-taking, which in turn increases the probability of a financial crisis and subsequent bailout.

“When creditors expect to be protected from losses, they will overfund risky activities, making financial crises and bailouts like those that occurred in 2007-08 more likely,” the report says.

For those reasons, the Richmond Fed advocates shrinking the financial safety net as a means “to restore market discipline and achieve financial stability.”

Some of the liabilities that the government guarantees may seem as American as apple pie. For example, the Federal Deposit Insurance Corp. insures bank deposits up to $250,000 — a commitment totaling $6 trillion in assets at commercial banks and savings institutions, and close to another trillion at credit unions.

But some of the liabilities are more surprising or controversial.

For example, uninsured domestic deposits are included in the tab because “most uninsured depositors were protected during the bank failures that occurred following the financial crisis that began in 2008.” The Richmond Fed’s estimate includes “implicit protection that people are likely to infer from past government actions and statements.”

On the controversial side, Fannie Mae and Freddie Mac, whose 2008 bailouts drew criticism amidst the financial crisis, effectively remain wards of the state seven years later. Through their conservatorship agreements, “Treasury has committed to ensuring that each entity maintains a positive net worth,” the report says. These so-called government sponsored enterprises account for over $5 trillion in potential liabilities.

Also controversial are private employer pension funds, over 98% of which are explicitly backed by the Pension Benefit Guaranty Corp., to the tune of nearly $3 billion.

A controversial implicit liability of nearly $3 trillion involves money market funds, which the Richmond Fed includes in its tab because the government extended its protection to these mutual funds in 2008.

However, the Richmond Fed is encouraged by new SEC rules set to take effect next year that will allow these funds’ net asset value to float freely, which may minimize the risk of investor runs if the funds are assumed to be perfectly safe investments.

Another perhaps surprising and controversial category includes “other financial firms,” that is nonbank firms including insurance companies, broker-dealers, even real estate investment trusts, that have been designated as systemically important financial institutions. These so-called SIFIs add another trillion in implicit government guarantees to the bailout barometer.

The Richmond Fed warns that its estimates could understate (or overstate) the potential liabilities.

For example, because the FDIC has indicated (on page 76,623 of a proposed procedure document!) that it would allow certain large firms to suffer losses, the Richmond Fed included liabilities of the largest four (“too big to fail”) banks but  not the next 35 largest institutions considered SIFIs (because their assets exceed $50 billion). But the report warns that market participants may view these institutions as implicitly covered anyway.

In any case, the Richmond Fed included just short-term liabilities of these 35 firms, in addition to all the liabilities of the Big Four.

On the flip side, the Richmond Fed says a case can be made that money market funds can already be taken off its list of firms that can expect government assistance.

Because the proportion of the financial sector that is subject to government guarantees has grown by a third since 1999, the Richmond Fed advocates the incorporation of resolution plans for financial institutions.

These “living wills,” as it calls them, can “be an important tool for establishing credibility against bailouts by making the government safety net the less attractive option in a crisis,” the report says.