Opinion

Hugo Dixon

Still too big to fail

By Hugo Dixon
September 16, 2013

Lehman Brothers’ bankruptcy five years ago crushed the global economy, turfed millions of people out of their jobs and left governments groaning under hefty debt burdens. Since then, policymakers have been beavering away to make sure that a similar calamity never happens again. Measures to address many of the key problems have been taken or are in the works. But if a Lehman went bust today, there would still be havoc.

The main success has been in building up the capital cushions banks have to withstand shocks. Since the end of 2009, the big global banks have increased their shareholder capital by $500 billion – the equivalent of 3 percent of their so-called risk-weighted assets, according to the Financial Stability Board (FSB), the organisation tasked by the G20 countries to fix the financial system. They are also on track to meet tighter global standards nearly five years ahead of the deadline.

But even this success has to be qualified. The amount of capital banks are supposed to hold depends on the riskiness of their loans. But lenders have too much freedom to decide for themselves how risky a loan is, giving them the opportunity to engage in monkey business. Meanwhile, inside the euro zone, the job of building capital buffers has not been properly done because of a tendency to sweep problems under the carpet. Thankfully, regulators are onto both these issues so there’s a reasonable chance they’ll be solved.

Less progress has been made in combating the “too-big-to-fail” problem. If a financial institution is too big to fail, governments have a terrible dilemma: either they let it collapse creating financial chaos; or they bail it out at huge cost to the taxpayer. Five years ago, they tried both methods: Lehman was allowed to go bust but, once they saw the mayhem, governments bailed out the other big institutions that were about to go belly up.

Beefing up shareholder capital should reduce the number of institutions that come close to bankruptcy. But there will always be some that fall through the net. The policymakers’ plan when this happens is to “resolve” the bust institution – effectively winding it down in an orderly fashion.

This, though, is easier said than done. For a start, there need to be laws allowing the authorities to grab failing banks and restructure them over a weekend before panic infects the rest of the financial system. Other creditors also have to be “bailed in” if there is not enough shareholder capital so taxpayers don’t foot the bill. There has been reasonable progress on these principles on both sides of the Atlantic.

Unfortunately, that is not enough if the failing institution is a large complex cross-border group like Lehman. When a bank has operations across the globe, either the authorities in one country need the power to swoop in and restructure the whole operation. Or the authorities in several countries have to swoop in together in a coordinated fashion. Whatever happens, there has to be a legal regime that allows this to occur. This is not yet in place, although the G20 promised to act at its St Petersburg summit earlier this month.

Then, there’s the question of complexity. Some financial institutions have such a tangled web of different legal entities – often constructed to minimise tax – that it would be impossible to resolve them in a weekend even with the best international collaboration.

The FSB’s answer to this problem is for regulators to engage in war-games with their banks to see if they really could be wound down in a crisis. If the regulators discover this can’t be done, they are supposed to tell the banks to simplify their structures. But it remains to be seen whether they will have the guts to push through radical structural changes if banks object, as they surely will.

And that’s not all. Even if regulators could resolve a complex cross-border institution, doing so could still trigger a panic among other institutions. The main reason for the post-Lehman contagion was that creditors of other banks and brokers ran for the hills fearing they would lose money too. In a resolution, creditors are supposed to suffer losses so there could still easily be a domino effect.

The FSB is finally focussing on this problem. Its solution is to require the big global institutions to have an extra tier of debt capital specifically designed to take a hit if the shareholder capital isn’t sufficient. The providers of this “bail-in” capital will know what they are letting themselves in for and will charge accordingly.

The idea is a good one. If another Lehman was resolved, the holders of bail-in debt in other institutions would, of course, get nervous. But they’d be locked in, so they couldn’t run. Other creditors, such as depositors and suppliers of wholesale funding, wouldn’t panic because their peers in the bank that had been resolved wouldn’t have been hit.

Still, the scheme only works if there is enough bail-in debt. Otherwise, the other creditors in the bank being resolved would get bailed in too – provoking contagion. At present, banks don’t have enough bail-in debt, although the G20 has asked the FSB to come up with proposals to remedy this by the end of next year.

The G20 also said it was “committed to maintain the momentum of reform until the job is done”. Hopefully, it means it.

Comments
4 comments so far | RSS Comments RSS

Lehman Bros caused the collapse of the financial house-of-cards in 2007? Really? The other too-big-to-fail financial institutions – Countrywide, Goldman Sachs, Citigroup, Bank of America, JP Morgan Chase, Wells Fargo, AIG, Fannie Mae and Freddie Mac and dozens of others had nothing to do with it? Amazing! History is being rewritten already.

Meanwhile, the Dud-Frank Bill has been endlessly debated for years with no funding to support enforcement of any of its potential provisions. The too-big-to-fail financial instututions have gotten bigger and even less regulated.

The promoters of the rescinding of Glass-Steagall are all now in favor of bringing it back, but that’s not going to happen.
THE PLUTOCRACY RULES ! !

Posted by ptiffany | Report as abusive
 

This is the United States of Corporate America. The government does not control anything anymore. They are a joint venture subsidiary of Corporate America.
The USA perished under Reagan, The USCA matured under G.W Bush. The only way to fix “to big to fail/prosecute” is to support the liberty Amendments.
A referendum vote on:
1. Term limits for Congress and SCOTUS.
2. Campaign finance reform

Posted by tmc | Report as abusive
 

The Banksters may not have been the major cause, but they caused the major damage. The government and the public can be excused for being stupid and controlled, but the banksters are “the smartest people in the room” as they like to remind us. No excuses for them.

Posted by tmc | Report as abusive
 

@tmc

Is your purpose to place blame or to fix the problem? If it’s to place blame, then you should include Bill Clinton who did away with Glass-Steagall and it was Barack Obama who failed to file criminal charges against any high ranking bank officials. In fact, it was Eric Holder who was recently quoted as saying, ” I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute — if we do bring a criminal charge — it will have a negative impact on the national economy, perhaps even the world economy.”

On the other hand, if we are going to talk about possible solutions to too big to fail and too big to jail, then perhaps we should talk about breaking up the four largest banks and increasing competition in the banking industry. As Bank Innovation points out, “We are now entering the third consecutive year of essentially zero new banking charters granted by the federal government.”

As Ron Hart says, “Where government intrudes, prices of goods and services rise at about twice the rate of inflation. Look at education, health care, energy, etc. Where the free market is allowed to operate, prices of electronics, cars, clothing (essentially anything they let Wal-Mart sell) rise less than the rate of inflation. Competition keeps prices down; government does not.” More regulation of the banks will inevitably favor the “Big Four” over small and mid size banks as the regulatory burden always falls hardest on the small and mid-sized businesses.

Posted by Lloyd_L | Report as abusive
 

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