De-TARP-ifying

Lately, several large banks, including Bank of America, Citigroup and Wells Fargo, have either paid back or completed negotiations to pay back the money lent to them by the federal government under the TARP (Troubled Asset Relief Program). In a sense, this is good: it's good to separate the banks from the government again. Temporary emergency measures have a disconcerting way of becoming permanent, so the quicker they can be reversed, the better.

But.

Before we're too quick to celebrate, we should remember that a great deal of damage has already been done. One reason why these banks have been able to raise private capital to replace the TARP money is precisely because of TARP, or rather, because investors now believe that their money is safe; the banks are "too big to fail," and shareholders won't be held accountable. That's not the way the capital markets are supposed to work.

To be sure, shareholders in the big banks have taken a hit. From September 15, 2008 (the date when Lehman Brothers declared bankruptcy and Bank of America bought Merrill Lynch) to yesterday's market close, the S&P 500 is down 11%. But over the same period, Wells Fargo is down 25.7%, B of A is down 54.3%, and Citigroup is down a massive 79.4%. But the latter two banks likely would have gone under without TARP, leaving shareholders with nothing.

The bully-pulpit nonsense about "fat-cat bankers" is really smoke and mirrors. If these banks are to be competitive, they have to pay their employees comparable wages and bonuses. The real problem is that no one was really punished, and in the end, we've just set up the next bubble. Investors in bank stocks are a little more certain that they'll be saved again the next time, which makes them a little less diligent in making sure their boards are watching out for them.

TARP may have (repeat: may have; we don't really know) prevented a massive wave of bank failures that could have brought our financial system to a standstill. But it was mishandled. Rather than trusting the capital markets to punish less-than-prudent investors, we're setting up a system where investors are kept safe, and trusting regulation to instill prudence.

A better system would be to have both. The capital markets need some regulation, because they are so critical to the operation of the country. But they also require free-market controls. Investors need to be fearful in order to be careful. We've just removed, or at least weakened, that safety line.