Putting an end to too-big-to-fail: An IM exchange

By Felix Salmon
June 18, 2009

The central banks in both the UK and Switzerland seem to be utterly fed up with the fact that their banking systems are full of too-big-to-fail banks. What can they do about it? I asked Peter Thal Larsen, in London:

Felix Salmon: Peter, it’s looking as though regulators in both the UK and Switzerland have reached the point at which they don’t want to have any too-big-to-fail banks at all. Is there a serious possibility that the likes of UBS, Credit Suisse, Barclays, RBS, HSBC etc will be split up into small-enough-to-fail chunks?

Peter Thal Larsen: It’s definitely the hot regulatory topic of the moment. I’m not sure we’re yet at the point where big banks are going to be broken up. But central bankers are clearly drawing a line in a sand: if banks are going to become large, they cannot do so on the taxpayers’ ticket.

FS: Yet it’s impossible for a bank with a trillion-dollar balance sheet not to be TBTF, right? And TBTF just means that ultimately taxpayers will pick up the bill if the bank runs into problems. So short of breaking up TBTF banks, what other options are there for taxpayers to lose that contingent liability?

PTL: Well, there’s a couple of options, neatly summarised by Mervyn King last night. You can force TBTF banks to hold much higher levels of capital as a form of insurance. Or you develop a bankruptcy process that allows you to wind down even large, complex banks in an orderly way. Though I’m still not clear how this would work in practice.

FS: King also suggested that separating retail banking from investment banking might be a good idea. Do you think that might help? My view is that given what happened to eg Northern Rock and Lehman Brothers, it’s far from clear that doing one thing badly is better than doing both things.

PTL: I don’t think a new Glass-Steagall is the answer. It’s too difficult to draw a line between the two activities, and if you do so without international agreement you just create an arbitrage opportunity. As you say, even narrow banks can fail. But my sense is that this is a stick that King is wielding in order to force banks to think seriously about the alternatives.

FS: So let’s say I’m a TBTF bank, and I’m feeling chastened by King’s speech. What can/should I do? Unilaterally break myself up for the Greater Good?

PTL: I doubt it will get to come that. But the TBTF banks do need to come up with a way of persuading the authorities that they can fail without costing the taxpayer a fortune. King described this as banks making a will. It may be complex, but it’s the least bad option. The alternative is that regulators will come up with more draconian solutions, as the Swiss did today.

FS: What’s the probability that the Swiss draconian solution is going to make its way into reality? And is it basically a combination of higher capital adequacy standards with a promise that if a bank gets into trouble, its retail-facing components would be saved while the rest of the bank would be allowed to fail?

FS: And isn’t there a basic credibility problem with all such promises? Aren’t they a bit like the US government saying that Fannie Mae and Freddie Mac debt didn’t have a US government guarantee?

PTL: Credibility is certainly a big issue. Though the Swiss seem to have made more progress on this than the rest of us. They’ve already pushed through higher capital requirements for UBS and Credit Suisse, and are now talking about having the power to rescue only the utility-like parts of those banks if there is a future problem. But the really explosive stuff is what they’re threatening to do if they can’t get agreement on new rules. They are talking about capping balance sheet size or asset-to-GDP ratios. So UBS and CS have a big incentive to co-operate.

FS: I’ve been throwing around a number of $300 billion as a sensible cap on balance sheet size. What do you think of balance-sheet caps?

PTL: It’s a blunt instrument, but it has the benefit of being simple and hard to game. As with all these rules, though, it needs some kind of international agreement to be workable. And it’s not enough in itself. Northern Rock’s balance sheet was $200bn, but it still had to be rescued because Britain didn’t have a proper deposit insurance scheme.

PTL: The other question, to which I don’t know the answer, is whether we need big banks to serve multinational companies. Or are we saying that only the US and China can have big banks, because they’re the only countries that can afford to rescue them?

FS: A cap makes sense as a step in the right direction, no? Big US banks aren’t going to be able to suddenly redomicile themselves if the US enacts a cap, and neither are the big Swiss banks. It might not be sufficient, but I don’t see the harm. As for servicing multinationals, you need international reach, for sure, but you don’t need a trillion-dollar balance sheet. Advice requires no balance sheet, and if you want to extend a loan, you can just syndicate it.

PTL: On size, I suspect you’re right. Ideally, you would put in place some kind of automatic factors that acted as a brake on banks getting bigger. In the past, banks had an incentive to become TBTF because they got cheaper funding if counterparties believed they would be bailed out. If you have a credible bankruptcy process, or make them hold more capital the bigger they get, banks will have to prove that there is a commercial logic to being big. Best to use the threat of a cap as a way of forcing banks to come up with a better solution.

FS: I like that, phone up the IIF and say “come up, by year-end, with a better way of counteracting incentives to grow too big, or else we’ll implement a hard cap”. When a banker knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.

PTL: That’s it. Use bankers’ naked self-interest to the public advantage. Which is why I think bankers have a real incentive to come up with a workable bankruptcy process. It’s their best hope for getting the government to leave them alone in future.

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