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Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Friday, January 21, 2011

SIGTARP: Citi Bailout Increased Moral Hazard

The Special Inspector General for the TARP Program released, on Jan. 13, 2011, a Report on Extraordinary Financial Assistance Provided to Citigroup, Inc. (Download SIGTARP.ExtraordinaryAsstnceCitigroup).  While it generally gives high marks to the government's efforts in bailing out Citigroup, it concludes with two significant reservations:

First, the conclusion of the various Government actors that Citigroup had to be saved was strikingly ad hoc....  Given the urgent nature of the crisis surrounding Citigroup, the ad hoc character of the systemic risk determination is not surprising, and SIGTARP found no evidence that the determination was incorrect.

Nevertheless, the absence of objective criteria for reaching such a conclusion raised concerns about whether systemic risk determinations were being made fairly and with consistent criteria. Such concerns could be addressed at least in part by the development, in advance of the next crisis, of clear, objective criteria and a detailed road map as to how those criteria should be applied....

Second, the Government’s actions with respect to Citigroup undoubtedly contributed to the increased moral hazard that has been a direct byproduct of TARP. While the year-plus of Government dependence left Citigroup a stronger institution than it had been, it remained, and arguably still remains, an institution that is too big, too interconnected, and too essential to the global financial system to be allowed to fail.  When the Government assured the world in 2008 that it would not let Citigroup fail, it did more than reassure troubled markets – it encouraged high-risk behavior by insulating risk takers from the consequences of failure.

Unless and until institutions like Citigroup can be left to suffer the full consequences of their own folly, the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results. Notwithstanding the passage of the Dodd-Frank Act, which does give FDIC new resolution authority for financial companies deemed systemically significant, the market still gives the largest financial institutions an advantage over their smaller counterparts by enabling them to raise funds more cheaply, and enjoy enhanced credit ratings based on the assumption that the Government remains as a backstop. And because of the prospect of another Government bailout, executives at such institutions might be motivated to take greater risks than they otherwise would.

The Dodd-Frank Act was intended in part to address the problem of institutions that are “too big to fail.” Whether it will successfully address the moral hazard effects of TARP remains to be seen, and there is much important work left to be done.... [I]t underscores a TARP legacy, the moral hazard associated with the continued existence of institutions that remain “too big to fail.” It also serves as a reminder that the ultimate cost of bailing out Citigroup.

 

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