Will They Get Fooled Again?

While it may not be the job of the Chairman of the Federal Reserve Board to deceive Congress to advance the interests of the big banks, apparently no one has informed Ben Bernanke of this fact.

Some people may recall the role that Mr. Bernanke played in helping to get the TARP through Congress. As part of the effort to build fear among members, he told Congress: "The credit markets aren't working. Corporations aren't able to finance themselves through commercial paper."

This was a big deal. Most large corporations are now dependent on selling commercial paper to finance their ongoing operations. They borrow money on the commercial paper market to meet their payroll and pay suppliers. If major companies were not able to sell commercial paper, they would quickly be unable to pay their bills and the economy really could shut down.

The extent to which the commercial paper market was actually in danger of freezing up is debatable. However, what is not debatable is the fact that the Federal Reserve Board had the ability to single-handedly keep the commercial paper market operating. In fact, the weekend after Congress approved the TARP, Bernanke announced that he was establishing the Commercial Paper Funding Facility. This facility directly purchased commercial paper from non-financial companies, ensuring that they had the money to stay in business.

In other words, even if the commercial paper market was shutting down, as Mr. Bernanke told Congress, there was no reason that Congress had to rush to pass the TARP. The Fed already had the ability to keep the commercial paper market going and Mr. Bernanke was prepared to exercise this authority before any TARP funds would be entering the system. Bernanke was helping to create the atmosphere of fear that was needed to get Congress to authorize $700 billion in TARP funds for the banks, with few substantive conditions.

It seems that Bernanke is again in his "fool Congress" mode. Yesterday he sent a letter to the Senate arguing that it should remove language that the Agriculture Committee put into the financial reform bill that would require banks to spin off their derivative trading units. The intent of this language is to separate out the business of the commercial banks, which operate with government insured deposits, from the more risky operations associated with derivative trading.

There are reasonable arguments that can be made on this issue, but these did not appear in Mr. Bernanke's letter. At the center of Bernanke's argument are two points that are just not true. He argues that the legislation would prevent banks from buying derivatives to hedge interest rate risk. This was not the intent of the rules and this is not how most people other than Bernanke are interpreting them. The issue is whether commercial banks should be acting as the intermediaries in trading derivatives, not whether they can buy derivatives as end users, just as any other end user would.

The other false concern raised by Bernanke is that derivative trading will be taken away from relatively closely regulated bank holding companies and transferred to more poorly regulated parts of the financial system. This is a false concern because the Ag Committee language only requires that the trading be taken away from the commercial banks that are protected by government insurance. Banks would be allowed to spin off divisions that are still within the bank holding company, however these divisions would not enjoy the special protections provided to commercial banks.

Finally, Bernanke effectively dismisses the concern that motivates removing trading from commercial banks by asserting that the era of "too big to fail" (TBTF) banks has ended. If Mr. Bernanke believes this, he is among a tiny minority of economists. While the financial reform bill includes many elements that will improve oversight and limit risk, there are few economists who believe that if Citigroup or Goldman Sachs were facing bankruptcy, the government would just allow them to collapse.

Of course the whole point of pulling derivative trading away from commercial banks is to ensure that taxpayers will not be liable for the mistakes that banks may make in the derivative trading business. Derivative trading is considerable more risky than the personal and business loans that are the normal business of commercial banks. If we assume that there are no banks that are now TBTF then we need not be concerned about a taxpayer bailout, but few, if any, economists would be as sanguine about this risk as Mr. Bernanke.

In short, this looks like the same sort of effort to misrepresent issues to Congress as we saw with the TARP. Mr. Bernanke is a very accomplished economist and he no doubt has much wisdom to share with Congress. It would be a big step forward if he saw this as being his job, instead of defending the interests of the big banks.