During the financial crisis, although the TARP program drew public attention, the bulk of the government’s assistance to financial firms came through the Federal Reserve’s emergency lending programs. The Dodd-Frank Act attempted to restrict this lending authority, but since its passage the Fed has failed to implement any concrete limitations. On September 16, Sens. David Vitter (R‑LA) and Elizabeth Warren (D‑MA), who had recently introduced a bill proposing specific limits on the Fed’s discretion, came to the Cato Institute to discuss the Fed’s authority and how best to curb it. Mark Calabria, director of financial regulation studies at the Cato Institute, moderated the event.

Mark Calabria: One of the things that really shook me and shook much of the public during 2008, 2009, were all these things happening that none of us really knew the Fed could do. The reaction in Dodd-Frank’s Section 1101 was to say, “Let’s tighten this up, let’s make sure that this is targeted toward everybody, that it’s solvent, that we aren’t bailing out firms, we’re just helping those that have a little bump in the road.” And, of course, about 20 months ago, the Federal Reserve proposed a rule — which, in my opinion, was largely just restating the statute. And so I’d like to start the conversation with: Is this something that the Fed cando on their own? If the Fed were listening, what would you say to them in terms of when we see a final rule, what it should look like?

Sen. David Vitter: Well first of all, let me back up a little bit and say that I think the fact that we’re here together working on this illustrates how broad and legitimate the concern across America is with “too big to fail,” and the fact that it is, unfortunately, alive and well. And if another crisis happened, we’re convinced we’d see it again, all over again. And I think the American public is really concerned about that — left, right, and middle. And the fact that we’re sort of the political “Odd Couple” working on this, I think it proves how deep and legitimate and broad-based that concern is.

Secondly, could the Fed fix this on its own? Certainly. Have they? Absolutely not. And it’s very clear, as you suggested, that they want to preserve maximum flexibility, their ability to do whatever they want, particularly in a crisis. And look, I’m not going to say that’s evidence of some evil hidden agenda. That’s sort of the natural impulse for an agency, to have as many tools in the toolbox as possible, to not restrict themselves. But it means that if it happens again, we would be assured of same old, same old: bailing out insolvent institutions, very focused bailouts. And so that’s why Elizabeth and I think our legislation, which would preclude that, is required.

Sen. Elizabeth Warren: Obviously I agree with David on this. I think he’s exactly right. This is about “too big to fail,” and what it means to the American people. It’s about what it means to this economy. It was all created in 2008, 2009. We know about TARP — try Googling “$700 billion” and see how many people were talking about TARP. But what a lot fewer people were talking about was how the Fed was shoveling money out the back door, in a very quiet way, not to support the financial system overall, but to support very targeted financial institutions.

Nine trillion dollars — your money, nine trillion tax dollars — went out the door to just three financial institutions, and it stayed there on average for about 22 months. And, yes, it was loan money, but at an interest rate that I guarantee those three financial institutions couldn’t get anywhere in the world except from the Federal Reserve.

So our bill actually has a real history to it in a sense. The first part is “too big to fail,” the second part is the response in Dodd-Frank. In Dodd-Frank, Congress came together and they said, look, if the Fed is going to lend any money in the future, in times of distress, we want to know that it’s a system-wide problem, not just that one or two financial institutions have a specific problem, and that the problem the financial institution has is not a problem of insolvency — that is, they have made some terrible bets in the market and they’re now upside down — but that the problem they’ve got is one of liquidity because the market itself is freezing up.

And, so, Congress, I think quite reasonably, in Dodd-Frank told the Fed to implement those goals. The Fed said, “Ah, system-wide … okay, we probably can’t say ‘one,’ Congress would get really angry about that.” So they said, “Two. Two counts as system- wide!” That’s it. So that’s all they’ve got to show, that you’ve got two financial institutions that are in here, asking for money at the same time. Then the next question is “Is this a financial institution that’s insolvent?” Now here, the Fed says, “Oh, we know how to measure if it’s insolvent — if they haven’t yet filed for bankruptcy.”

I want you to just think about that for a minute. Because the way I read that is they said, “Well, we’re going to set up a little cart right in front of the bankruptcy courthouse and any large financial institution that has prepared the papers and is headed into the courthouse, we’ll just intercept and say ‘Would you like a trillion dollars from us instead? Because you will qualify, because you have not yet climbed the steps and dropped a piece of paper that files for bankruptcy.’ ”

Let’s face it. That is not what Congress intended in Dodd-Frank, but it is also not what we need in order to try to beat back the “too big to fail” problem. So, what Senator Vitter and I have proposed is just to go back over those three parts. And we talk about system-wide and we say “We didn’t think we would have to do this by statute, but come on, guys. Five institutions. Let’s at least get the number up. And you guys have got to go out there and certify that this is not an insolvent financial institution that’s getting this money. At least you’re going to have to put your name behind it.”

And the third part is that this should be at a penalty rate of interest. It should be five points above what the Treasury bill is. The point here is not to give you below-market rates so that we can subsidize you. The point is to say, if you’re having to turn to the Fed for help in a crisis, then the Fed should be like other market lenders. They’ll be there as lender of last resort, but you’re going to have to pay something extra for it, and your shareholders are going to have to pay extra for it. So we still give the Fed the capacity to move in, but we feel like we’ve tried to at least put some curbs on this so that we can get “too big to fail” under better control.

Calabria: I think that’s an incredibly important aspect, reminding people that markets don’t work without failure. Neither one of you will be surprised that there’s been some criticism, so let’s try to raise a couple of those. I won’t name them, but a recent federal official testified before Congress and made the argument that we really don’t know at the time who’s insolvent. We can’t figure this out at the time, and you have to just trust our judgment.

Warren: Really?

Calabria: I’m trying to be generous to the critics.

Warren: But I’m serious. Really? These are supposed to be the supervisors and regulators who are out there looking at the books, assessing the assets every single day. That’s their job. And if we’re heading into crisis, it’s not like we all get up one morning and, with no warning at all, whoa! It’s 11: 50 and suddenly there’s a financial crisis upon us. You know that there’s trouble. That means they should be stepping up their scrutiny of these institutions. The idea that they can’t tell — if that is a serious statement then I am genuinely terrified.

Vitter: I agree. I think they clearly have the ability to ascertain that. Looking in the past, we can clearly say that most of these cases we’re talking about were insolvencies and we knew it at the time. And our goal is not simply to limit alternatives in a crisis. Our goal is to do this way ahead of time so that we do other things to head off a crisis. And I think having all of these opportunities and unlimited powers really is a reason for the feds and others not to do things ahead of time to avoid the crisis.

Calabria: I sometimes hear the “stuff happens” argument: “Well, you’re going along and everything’s fine and then, boom, some shock out of the blue and then we’ve got to bail these guys out, we didn’t see it coming.” And, so, I certainly worry — and I would be curious whether we share this concern — that by having the expectation of this facility we change the behavior of the companies themselves, their creditors, their counterparts.

Warren: I think that goes right to the heart of it. If you advertise to the market that the Fed is here and there’s no need for any large financial institution ever to have to go to the bankruptcy courthouse or declare itself insolvent, but, instead, there will be trillions of dollars available to back up these giant institutions, I think that fundamentally changes the behavior of the big banks themselves, the behavior of those who lend them money, the behavior of those who invest in them. And I’ve got to say in all three cases, not for the better, because it encourages riskier behavior, knowing that there is an option available.

Vitter: If “stuff happens,” a legitimate question is: Okay, does having this facility available all over again encourage bad stuff to happen or discourage it from happening? I think it clearly encourages it. And that’s exactly the dynamics we’re trying to change. There’s been study after study after study that says: number one, “too big to fail” is alive and well; number two, it gives megabanks a market advantage, a lower cost of capital, other market advantages that are simply unfair and are onerous to competitor institutions.

Calabria: I think the evidence is pretty clear that these have resulted in higher leverage than you would have otherwise. It’s important to rely on the financial regulators but to me it’s also important that, let’s say I had a billion dollars to lend you. If I did lend it to you, I’d probably care what you did with it. I believe Lehman had at least three offers to be bought, and every time, they said, “No, we’ve got this backup.”

Warren: “We got a better deal somewhere else.” And the thing is, you’ve got to think about that in terms of the behavior that that encourages from Lehman, from its creditors. But it’s also what it does to a market overall. So you’re a community bank, you’re a small bank, or a mid-sized bank, but you’re not going to be “too big to fail.” You’re out there competing for capital, you’re competing for investments, and you’re competing against somebody that doesn’t just have a government guarantee, they’ve got a government guarantee for free, to back them up. And the more you keep that playing field tilted, over time the more we’ll see more concentration in the industry. You’re driving one set of competitors out of business and advantaging another set of competitors, a set of competitors that ultimately pose far greater risk to the economy.

Vitter: To me, the ultimate irony is we come out of the crisis, and I think mostly what we’ve done is create a greater disadvantage to the smaller players who essentially had nothing to do with the crisis. So we’ve tilted the playing field even further in favor of megabanks, against smaller community banks and credit unions.

Calabria: I agree that a lot of this has to be about leveling the playing field. I want to go back to another criticism of your plan: that a penalty rate of 5 percent will scare away anybody from using this facility.

Warren: You mean they’ll say instead, “I’m going bankrupt! I am not going to pay five extra points”? Please. It’s just an alternative view of human behavior that I don’t buy. They borrowed from Warren Buffett at 10 points. The idea that you won’t do it here just makes no sense to me.

Calabria: I would agree. Part of this should be making the Fed actually a lender of last resort rather than being a rescuer of first resort.

Vitter: I’d love to see the Fed come up with a similar rule on its own. But quite frankly, even if they were to do that tomorrow, which they’re not going to, my concern would be that they can change that at a moment’s notice in the middle of a crisis too. So I think, for all sorts of reasons, it’s better to have broad parameters like we’re talking about in statute.

Calabria: This is an odd pairing, as you said, that’s worked, because last night the Senate passed a bill on Government-Sponsored Enterprise compensation that you two authored. I’m curious what the interest is from the rest of the Senate in this approach.

Vitter: I think this is sort of a competition between two factors. Number one, the public’s legitimate concern with “too big to fail,” favoring megabanks, all of that broad-based discussion. Number two, the insider game of these institutions, which are very powerful and influential. And, so far, quite frankly, the public debate hasn’t been big enough, loud enough, to overcome the special interest game, but I think it’s growing in that direction.

Warren: I always think of it this way: the public interest here, there is no army of lobbyists representing them. There is no army of lawyers coming in every day to talk to every Senate staff, to make sure that their position is well known. The question is: Will the insiders control the game? Those who’ve got the lobbyists, those who’ve got a lot of money on the table but a very small insular group that, frankly, wants to enhance its profits at the expense of the public? Or will we really be there to represent the people who are affected by this? Both in the overall financial system and, God forbid, when we hit the next crisis.

Vitter: I’ll give you an example. Months ago, one of the early things I did with others was to have language mandating a study of the costs of “too big to fail” and quantifying that. A pure study, by objective analysts. The megabank lobbyists came out of the woodwork in enormous force. I knew they were there. I certainly understood they would oppose it. Still, it stunned me that they would come out in full force over doing a study and putting some numbers on it. That’s the insider game I was trying to describe. We need to overcome that with broad-based public debate.

Calabria: I used to often say there’s no narrowly defined constituency for financial stability, unfortunately. And of course one of the reasons we’re here today is to try to create that. It’s one of the reasons that Cato is working with Americans for Financial Reform to try to build broader understanding of this. I think we can have a stronger and simpler regulatory system. Of course, my little pet peeve is the capital standards and every time they tell us they’re going to do these risk weightings and it’s going to be ever more complicated and it’s just more and more opaque. We’ve seen the various rounds of the Basel accords end up with lower capital, rather than more, and that’s why I’m very sympathetic to a flat, simple leverage ratio that everybody can kind of read and know. So I do think that that, to me, is where the left/​right deal is. Simpler, stronger, more transparent.

Warren: The issue around “too big to fail” is too big for politics. We can’t just leave this to business as usual, that a group of insiders will influence those with power, and as a result we’ll end up with a set of rules that works for the very largest financial institutions but doesn’t work for other financial institutions, doesn’t work for the American economy, and doesn’t work for the American people