Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
On Tuesday, with some fanfare, the Bipartisan Policy Center in Washington rolled out a report, “Too Big to Fail: The Path to a Solution.” Focused on how to “resolve” big financial companies — a technical term for the details of handling the failure of such institutions — the report is elegantly written and nicely laid out. You can either read the very short version, the short version or the long version of the same material. Unfortunately, in all three the authors fail to persuade that the problem of too-big-to-fail is fixed or can be brought under control if only we follow their recommendations.
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Their argument has three elements. First, big financial companies can be resolved either in bankruptcy or, more likely, through using the orderly liquidation authority, or O.L.A., created by the Dodd-Frank Act of 2010. Second, the key to making O.L.A. workable is sufficient “loss-absorbing” long-term debt and equity at the holding-company level. Third, the implication is that most or all of the big banks already have sufficient “loss-absorbing” debt and equity at the holding company level to make this work.
As a result, the authors contend, we (or perhaps financial-sector executives) are in luck — no significant structural changes, like simplification or reductions in scale, are needed at megabanks.
All three parts of this argument are unconvincing — and the bottom-line policy implication, “do little, be happy,” is downright dangerous.
The first point about the workings of bankruptcy and O.L.A. may sound good on paper but is simply not plausible in the real world. We are talking about huge, complex and opaque companies — typically including hundreds of thousands of employees across more than 100 different countries, with 2,000-plus legal entities. Even well-informed investors cannot figure out where the risks really lie — and the recent London Whale experience at JPMorgan Chase raises questions about whether officials or even company managements have much more of a clue.
The exercise of having large bank holding companies draw up “living wills” to show how their failures could be handled under normal bankruptcy procedures (part of the Title I requirements under Dodd-Frank) is widely regarded as having yielded little or nothing of value. There will be a do-over later this year, but I have yet to find a well-informed person — in either the private sector or government — who is optimistic about the outcome.
In addition, the United States authorities have so far failed to designate a single nonbank as systemically important — and thus subject to additional prudential requirements (a technical term, meaning closer scrutiny and supervision), including preparation of a living will. The authors show no awareness of the painful lessons from A.I.G., Lehman Brothers and the run on money funds in September 2008. None of those entities were banks (a specific legal and regulatory term), but this report seems oblivious to the implications.
If the market questions, and it does, whether the Federal Deposit Insurance Corporation could handle the failure of a single big bank holding company (already subject to close supervision, in principle), what are the chances of persuading anyone that a significant nonbank financial institution could be resolved in an orderly fashion?
To be fair, the authors of the Bipartisan Policy Center report would like to modify the bankruptcy code — adding a new Chapter 14 (an idea that originated with the Hoover Institution). But why should the financial sector, or anyone else, get special treatment? If we are going to use bankruptcy when companies fail — and this would be my strong preference, if I thought it could be done without destroying the world economy — surely there should be one set of rules for everyone.
Once you establish special treatment and break with precedents, the entire legal process becomes murky, unpredictable and likely to spread more fear than confidence in the outcomes.
Of course, megabanks and other systemically important financial companies cannot go through bankruptcy today without generating the risk of a broader economic collapse — again, one lesson from the fall of 2008. An obvious response would be to induce these companies to change the structure, scale and nature of their activities in order that their failure could be handled by bankruptcy. This is precisely the intent of Title I in Dodd-Frank.
The authors of this report, however, prefer instead to rely on the orderly liquidation authority, including the proposed “single point of entry” for bank-holding companies. In the current version of this plan, the F.D.I.C. would take over a failing institution and force recapitalization at the holding-company level through wiping out equity holders and converting long-term subordinated debt owed by the holding company into equity, while allowing operating subsidiaries to continue in business and to pay their liabilities in full.
I fully support the F.D.I.C. in its attempt to build a workable O.L.A., and there are presumably situations in which this set of tools could help. (I’m a member of the F.D.I.C.’s Systemic Resolution Advisory Committee, but the views here are mine alone.)
But I have not heard any of the relevant responsible officials express the kind of frothy optimism for O.L.A. that bubbles through in this report.
The authors do cite a recent speech by Mary Miller, under secretary for domestic finance at the Treasury Department, in which she says that too-big-to-fail is substantially fixed by the O.L.A. and other measures. But, as John Parsons and I pointed out at the time, her speech is deeply flawed at many levels and absolutely does not represent the public views of the F.D.I.C. or the Federal Reserve.
Regarding whether she provides a realistic assessment of O.L.A., Ms. Miller’s language actually confuses liquidation — the closing of a company and the winding down of its activities — with resolution (see Page 6 of her speech). I pointed out this problem two weeks ago to the Treasury Department; unfortunately, it has made no discernible attempt to tighten the wording or issue any kind of clarification.
The second point in the Bipartisan Policy Center report’s argument completely misses the key systemic issues, including the basic mechanics of how global crises spread.
The authors do mention the issues of global resolution — handling a financial failure across borders — but only to dismiss the thorny realities as trivial. As for the report’s recommendations, regarding global resolution these amount to exhorting the F.D.I.C. to get foreign countries to cooperate (good luck) and to threatening to bring Congress back in to legislate cross-border cooperation (a legislative and diplomatic impossibility).
The authors are top experts (legal and financial), so surely they have been following the news from Europe, including a series of botched bank rescues, the debacle in Cyprus and now a row at the highest political levels about whether to protect uninsured depositors more or less than bondholders. Not surprisingly, the split is between countries where such depositors have more sway (e.g., France and Spain) and those where bondholders have a stronger voice (e.g., Britain and Denmark). Who will get what kind of support — or be forced to swallow a bail-in (i.e., take losses) in a potential crisis?
It is impossible to say with any accuracy.
Writing in The Financial Times on Monday, Wolfgang Schäuble, Germany’s finance minister, made it clear that we are a long way from having an integrated bank resolution regime in Europe. In a crisis, it’s every finance minister and central banker for himself.
This matters a great deal because, as the Federal Reserve governor Jeremy Stein pointed out in a recent speech, the costs of financial stress are felt not just when there is an outright failure but also when financial institutions suffer losses and come under pressure. In terms of macroeconomic impact, “near collapse” can be almost as damaging as actual failure, particularly amid great uncertainty about who will bear what kind of loss.
And this leads to perhaps the greatest deficiency in this report: a complete failure to discuss the importance of who holds the quasi-mythical “loss-absorbing debt” at the holding company level. If such debt is held by highly leveraged institutions, with or without obvious systemic importance themselves, then a sharp fall in the value of this debt (leading up to the forced conversion into equity) can help spread a crisis far and wide.
The same problem exists for money-market funds, which remain highly susceptible to runs. Would it be stabilizing or destabilizing if a large amount of this debt were held across borders?
And who will be allowed to insure this debt, through credit default swaps or in some other complicated way using derivatives? If Goldman Sachs insures any kind of bail-in liabilities of JPMorgan Chase (or another megabank), that should make us very worried.
Third, all roads lead to equity capital, in a way that the authors of this report fail to appreciate fully.
If the big banks really had sufficient equity to absorb likely losses, we would be discussing equity levels close to those proposed in legislation by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana. (I wrote in more detail last month on Bloomberg View about Brown-Vitter and its impact so far.)
But the Bipartisan Policy Center report takes the view that such levels of equity funding (relative to total assets) are a bad idea. The wording here seems close to that in a recent document issued by Davis Polk Wardwell, a law firm (not surprising, as one of the authors of the center’s report is a senior person at that firm). Both Davis Polk and this report are completely wrong on equity — a point that I made in this blog recently (including the misinterpretation of the pivotal new book by Anat Admati and Martin Hellwig).
At least implicitly, the report is putting great weight on long-term subordinated debt at the holding company level. How much is there?
Moody’s, the rating agency, issued a report on this question in March (“Reassessing Systemic Support in U.S. Bank Ratings – an Update and F.A.Q.”). There is more than one way to do the relevant calculations, but Moody’s entirely plausible methodology suggests that total capital subject to a bail-in (equity plus the right kind of debt at the holding company level) is 4 or 5 percent of total assets for some of our biggest banking conglomerates (see Exhibit 3 in that report).
I’m comparing bail-in capital with total assets, not risk-weighted assets – as the risk weights are wrong in every crisis. However, I would caution that Moody’s does not adjust these debt numbers according to whether they are held by bail-in creditors – i.e., entities on which the F.D.I.C. would actually be willing to impose losses.
Next, we should expect megabanks and their representatives to whine that reasonable levels of bail-in capital (e.g., 20 to 30 percent of total assets; see Pages 7 and 8 of this letter to the Fed by Sheila Bair, Professor Admati, Richard Herring and me) — and a conservative definition of bail-in creditors — will crater the real economy. We hear this assertion every time financial reforms are discussed. For example, the financial consulting firm Oliver Wyman (which is also involved in the Bipartisan Policy Center report) made this point on the Volcker Rule; see my assessment).
The Bipartisan Policy Center report depicts a pair of mythical beasts — the perfect orderly liquidation authority and its partner, the bail-in creditor. More broadly, this appears to be part of a concerted effort by megabanks and their allies to convince you, and the Board of Governors of the Federal Reserve, that the existence of these beasts will hold all other evils at bay.
Such mythical beasts do not exist in the real world.
Article source: http://economix.blogs.nytimes.com/2013/05/16/the-myth-of-a-perfect-orderly-liquidation-authority-for-big-banks/?partner=rss&emc=rss