April 23, 2024

Economix: The Problem With the F.D.I.C.’s Powers

Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Under the Dodd-Frank financial regulation legislation (in Title II of that act), the Federal Deposit Insurance Corporation is granted expanded powers to intervene and manage the closure of any failing bank or other financial institution. There are two strongly held views of this legal authority: that it substantially solves the problem of how to handle failing megabanks and therefore serves as an effective constraint on their future behavior, and that it is largely irrelevant.

Both views are expressed by well-informed people at the top of regulatory structures on both sides of the Atlantic, at least in private conversations. Which view is right?

In terms of legal process, the resolution authority could make a difference. But as a matter of practical politics and actual business practices, it means very little for our biggest financial institutions.

On the face of it, the case that this power to deal with failing banks — known as resolution authority — would help seems strong. Timothy F. Geithner, the Treasury secretary, has repeatedly argued that these new powers would have made a difference in the case of Lehman Brothers.

And a recent assessment by the F.D.I.C. provides a more detailed account of how exactly this could have worked.

According to the authors of the F.D.I.C. report, if its current powers had been in effect in early 2008, the agency could have become involved much earlier in finding alternative ways –- that is, unrelated to the bankruptcy process –- to “solve” the problems that Lehman Brothers had: very little capital relative to likely losses and even less liquidity relative to what it needed as markets became turbulent.

The F.D.I.C. report describes a series of steps that the agency could have taken, particularly around brokering a deal that would have involved selling some assets to other financial companies, such as Barclays, while also committing some money to remove downside risk –- both from buyers of assets and from those who continued to own and lend money to the operation that remained.

If needed, the F.D.I.C. asserts, it could have handled any ultimate liquidation in a way that would have been less costly to the system and better for creditors, who will end up getting very little through the actual court-run process.

But there are two major problems with this analysis: it assumes away the political constraint, and it ignores the most basic reality of how this kind of business operates.

At the political level, if you wish to engage in alternative or hypothetical history, you cannot ignore the presence of Henry M. Paulson Jr., then secretary of the Treasury.

Mr. Paulson steadfastly refused, even in the aftermath of the near-collapse of Bear Stearns, to take any active or pre-emptive role with regard to strengthening the financial system –- let alone intervening to break up or otherwise deal firmly with a potentially vulnerable large firm.

For example, in spring 2008, the International Monetary Fund — where I was chief economist at the time — suggested ways to take advantage of the lull after the collapse of Bear Stearns to reduce downside risks for the financial system.

Compared with the hypothetical variants discussed by the F.D.I.C., our proposals were modest and did not involve winding down particular firms. Perhaps in retrospect we should have been bolder, but in any case our ideas were dismissed out of hand by the Treasury.

Senior Treasury officials took the view that there was no serious systemic issue and that they knew what to do if another Bear Stearns-type situation developed –- it would be rescued by another ad-hoc deal, presumably involving some sort of merger. (Bear Stearns, you may recall, was taken over by JPMorgan Chase at the 11th hour, with considerable downside protection provided by the Federal Reserve.)

Mr. Paulson was very influential, given the way the previous system operates, and his memoir, “On The Brink,” is candid about why: he had a direct channel to the president, he was the most senior financial sector “expert” in the administration, and he was chairman of the President’s Working Group on Financial Markets.

Under the Dodd-Frank Act, however, he would have been even more powerful — as head of the Financial Stability Oversight Council and as the person who decides whether to appoint the F.D.I.C. as receiver.

It is inconceivable that the F.D.I.C. could have taken any intrusive action in early 2008 without his concurrence. Yet it is equally inconceivable that he would have agreed.

In this respect Mr. Paulson was not an outlier relative to Mr. Geithner or other people who are likely to become Treasury secretary. The operating philosophy of the United States government with regard to the financial sector remains: hands off and in favor of intervention only when absolutely necessary.

In addition, as a senior European regulator pointed out to me recently, the idea that any agency from any one country can handle a resolution of a global megabank in an orderly fashion is an illusion. Even if we had agreement among countries on how to handle resolution when cross-border assets and liabilities are involved — which we don’t — it would be a major mistake to assume that such a resolution would have no systemic consequences, that same person said.

These financial services companies are very large — more than 250,000 employees work for Citigroup, which operates in 171 countries and with more than 200 million clients, according to its Web site. The organizational structures involved are complex; it is not uncommon to have several thousand legal entities with various kinds of interlocking relationships.

Sheila Bair, the head of the F.D.I.C., has pointed out that “living wills” for such complicated operations are very unlikely to be helpful. Perhaps if the financial megafirms could be simplified, resolution would become more realistic (and the F.D.I.C. report, mentioned above, alludes to this possibility in its conclusions).

But any attempt at simplification from the government would need to go through the Financial Stability Oversight Council, where the Treasury’s influence is decisive.

And the market has no interest in pushing for simplification — anything that makes it harder to rescue a big bank, for example, will increase the probability that, in the downside situation, it will receive a too-big-to-fail subsidy of some form.

Many equity investors like this kind of protective “put” option.

F.D.I.C.-type resolution works well for small and medium-sized banks, and expanding these powers could help with some situations in the future. But it would be an illusion to think that this solves the problems posed by the impending collapse of one or more global megabanks.

Article source: http://feeds.nytimes.com/click.phdo?i=9e81bd0ddbfac9dc700508d73af30738

Speak Your Mind