This Is Their Reform Strategy For Big Banks?

Anil Kashyap is one of our leading researchers on banks.  His book with Takeo Hoshi on the evolution of the Japanese corporate finance is a must read on the twists and turns that built a great economy and then laid it low.  And he has many other papers and relevant recent commentary.

Professor Kashyap has a sharp perspective the administration’s financial sector reform thinking, in part because he has long worked alongside key people now at the National Economic Council (the NEC, by the way, has disappointingly little transparency; even Treasury is more open).

So we should take him seriously, writing Tuesday in the Financial Times, on the importance of the proposed new “funeral plans” for banks.

Kashyap’s point is that if banks are forced to explain, in convincing detail, how they can be wound down, this will effectively limit the complexity and scale of their operations. (See “Rapid Resolution Plans” on p.25 of the regulatory reform proposals; p.26 in the online NYT version)

The notion is intriguing, if such rules are actually enforced.  Essentially, banks would be required to specify the extent and nature of costs for any bailout they may require.

A key part of any plan would be the people involved.  Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)?  Would they therefore require large retention bonuses?  How large exactly?

You can see how such resolution planning might go wrong – particularly if banks were only forced to consider whatever they now regard as “normal” risks.  Remember the head of quantitative equity strategies who said, in early August 2007, “Events that models only predicted would happen once in 10,000 years happened every day for three days.”

A checklist approach is definitely not going to work (been there, done that, for countries).  You need something that can simulated or, even better, played out in a war game.  Bring in some difficult outsiders and try to break the bank in the messiest way possible (in a game), then follow the consequences and costs.

These banks are so large and intertwined with so many other, it’s hard to fathom how a “funeral plan” would be reassuring – unless it means that they become smaller and less complex.

And this brings up the real weakness of this approach to reform – the political economy.  How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup or JP Morgan Chase?  The CEOs of those firms have direct access to the Secretary of the Treasury and on Pennsylvannia avenue they are regarded as gurus and bastions of the economy.  They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.”  Which recent Treasury Secretary would be able, at that moment, to face them down – particularly as these bankers can, if pushed, go to the big boss?

On top of this, keep in mind there is no cross-border resolution authority currently on the table in the US regulatory reform proposals or at the G20 level.  The Europeans say they are inching in this direction; I’ll believe that when I see it.  In our next boom-bust iteration, big banks may well be regarded as having “too many cross-border liabilities to fail”, so there’ll be another quasi-bailout with potentially huge fiscal costs.

And then someone will promise a new regulatory reform plan.

By Simon Johnson

26 thoughts on “This Is Their Reform Strategy For Big Banks?

  1. “Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)?”
    It is the case for AIG FP or more precisely for its affiliate Banque AIG, that bank is regulated in France by the Commission Bancaire, and the regulator has the sole authority to approve who is or isn’t a fit person to run the place, not AIG. When 2 top individuals resigned, efforts were made to keep them on board (successfully) as their departure would have triggered a change of control event which in turn would have given banque AIG counterparties the right to terminate their contracts. I will let you guess the cost but since the notional CDS outstanding was at the time well north of $200 billion, it is sure to be many orders of magnitude that of the retention bonus.

  2. It would certainly be helpful to require large banks to develop “funeral plans.” It would also help if banks were less leveraged. This would have to be done without putting commercial banks at a competitive disadvantage vis-a-vis shadow banking. It is in the public interest to drop the corporate income tax on regulated commercial banks (or cut the rate and limit the deductibility of interest). It would also help if unsecured bank debt could be converted into equity at the initiative of bank managers when market capitalization falls into the danger zone. Finally, the tax advantages of certain leveraged management compensation schemes should be eliminated (or reversed) for regulated commercial banks.

    All these changes would go a long way towards protecting the taxpayer and the financial sector the next time around – which is sure to come sooner or later. The advantage is that they do not require a massive expansion in the scope and discretion of government regulation. Nor is it clear why the banking sector would oppose them.

  3. At the end of the day, it is individuals that count – as always. They count in three respects: as architects of a basic restructing of our current dysfunctional financial system; as political entrepreneurs,e.g. the White House; and, finally,as those who would direct and oversee the execution of a serious plan. The last has gotten the least attention – in part because of egregious failure at the first two stages. Today’s essay brings the question back into the limelight. The difficulty in identifying persons of integrity, knowledge and a well developed sense of the commonweal highlights a degeneration in our public life that goes beyond its corruption by self-serving financial interests. Who other than Paul Volcker is out there? Professor Warren? Professor Johnson? I, as well as others, would be grateful for some nominees. Their names might be sent to the White House for consideration when, at some point down the line, the President divorces the toxic bunch to whom he has given the levers of power.

    Michael Brenner

  4. By William K. Black

    “As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an “epidemic” of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.1 When the person that controls a seemingly legitimate business or government agency uses it as a “weapon” to defraud we categorize it as a “control fraud” (“The Organization as ‘Weapon’ in White Collar Crime.” Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds’ “weapon of choice” is accounting. Control frauds cause greater financial losses than all other forms of property crime — combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a “criminogenic environment” (Big Money Crime. Calavita, Pontell & Tillman 1997.)”

    Read more here:

  5. Michael Brenner: “The difficulty in identifying persons of integrity, knowledge and a well developed sense of the commonweal highlights a degeneration in our public life that goes beyond its corruption by self-serving financial interests. Who other than Paul Volcker is out there? Professor Warren? Professor Johnson? I, as well as others, would be grateful for some nominees.”

    A government of laws is better than a government of men, but you still need people to enforce the law. For the ueber-regulator for finance you do not need someone with deep knowledge of finance or economics — they will have plenty of experts to advise them –, but you do need someone who will enforce the law. Because of potential conflict of interest, cronyism, or regulatory capture, it would make sense to get someone from outside the industry. Strange as it may seem, the person who comes to my mind is Arnold Schwarzenegger. Whatever you may think of his politics, he has the requisite backbone.

  6. “We cannot discuss how we emerge from the present crisis unless we understand how we entered the present crisis. ”

    I agree with John Kay in this. He then gives his causes in the post I’m referring to. I would say that the real fear is a Debt-Deflationary Spiral, and probably add a few more causes to his list. But we agree on the solution:

    “The way forward: restore narrow banking
    We need to restore narrow banking – to ensure that the casino cannot again jeopardise the utility. That means ringfencing the payments system, the routine deposit taking and the lending to consumers and to small and medium-sized businesses. There are several measures that might help towards this objective and a combination is probably appropriate. I suspect the outcome will now be best achieved by taking the failed banks into direct public ownership for a period.

    Measures to re-establish narrow banking will necessarily involve the divestiture or closure of the investment banking activities of retail banks. Such restrictions will provide an opportunity to reintroduce measures of structural separation between fundamentally incompatible wholesale financial activities. The causes of the crisis, and the remedial measures now required, are embedded in the structure of the modern financial services industry. Addressing these structural issues, which will require high political courage, is a prerequisite of policies to prevent a similar crisis re-emerging a decade from now.

    John Kay is visiting professor at the London School of Economics and Political Science and a columnist at The Financial Times ”

    All other solutions allow for too much wishful thinking. A Bank Will will be a document written by someone who never plans to die. It will recommend life sustaining measures, with no pull switch. Good luck with this idea.

  7. “Remember the head of quantitative equity strategies who said, in early August 2007, “Events that models only predicted would happen once in 10,000 years happened every day for three days.””

    Isn’t this Taleb’s point, that the math of Mandelbrot should be the math used in assessing risk? He says Gaussian formulas don’t asses risk adequately. And without adequate assessment, would estimates be accurate of what the cost of “unwinding” will be?

    It’s not just about the frequency either, it’s also about the severity created when the risk arrives.

  8. Why is this answer to every proposal to regulate accepted at face value?

    They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.”

    Wasn’t the expansion of leverage and consumer credit one source of the problem? Why isn’t less credit (especially to those clearly unworthy of the responsibility) the proper answer to the problem?

    I’m lost.

  9. How can you hold companies accountable for accuracy in funeral plans?

    That’s easy: hold their executives civilly liable for negligent underestimation of risks and criminally liable for reckless or intentional underestimation of risks.

    That way, when the government bails out the next company with cowboy executives, at least there will be someone to burn at the stake. And, if those cowboy executives see others burned at the stake, they will be more likely to produce reasonable well thought out and estimated wind down plans in the future. Then, we could place reasonable reliance on those wind down plans in setting up a bailout insurance fund, with higher premiums charged to those running riskier operations.

    I’d sign on to that. And I’d be willing to trade a lot of smoke and mirrors regulation run by a captured regulatory agency in exchanged for such a regime. In fact, let the executives opt-in or opt-out of the system. They could choose: subject their company to a “restrictive” regulatory body (which is still better than nothing even if the agency is captured), or hold themselves accountable in a free-wheeling system that challenges the executives to put their money and their liberty where their mouth is.

    There’s nothing like watching an executive face a real regulator — a jury — after their sh*t has hit the fan, and the taxpayer’s pocketbook.

  10. The proverbial White Elephant in the Room is called: Bank Nationalisation. Over at the BBC Reith lectures Michael Sandel says:

    “The jury is out on what the political identity of the Obama presidency will ultimately be, and the handling of the financial crisis does give reason for pause, hesitation, and even, I would say, some concern.

    “So what would another approach look like? Well some people say that nationalising the banks in the public interest would have been a better, more frontal, and ultimately simpler, cleaner way of doing it.

    “It would have had one advantage, which would be to make explicit that the purpose here is the public purpose and however we resolve the financial crisis, we should do so in a way that minimises the unfair advantage to be enjoyed by bankers and investors whose conduct of their companies got us into this mess in the first place.

    “And nationalising would at least send that message in a way that a complex, public-private partnership involving yet more leverage doesn’t.

  11. Actually, I’m not sure Taleb is on point (though I love the book).

    As I understand it, the black swan is an extremely improbable (though inevitable) event. You have a flat line, then a single spike, then a flat line again — rather as if a cosmic ray caused your server to fail, and it was then rebooted.

    By contrast, the financial crisis (The Big FAIL) was predicted by many for quite cogent reasons, but the people who called their shot accurately were shunned as Cassandras.

    The fault is not in our math, dear Brutus…

  12. This was my letter to the editor in FT on this article

    For a good obituary you need a good life.

    Anli Kashyap in “A sound funeral plan can prolong a bank’s life” writes about “the rapid resolution plan” that systemically important financial would have to file indicating what arrangements they have made for their demise.

    It sounds so right and so utterly responsible (even Angela Dorothea Merkel would be expected to endorse that) but, do we not really need more a little mission statement about what they are going to do while living? We still keep on worrying too much of keeping the costs of the funeral down instead of making certain that the living has been worth it. In these financial regulatory reforms, where do they really discuss the purpose of the banks?

    The possibilities of a “rapid resolution plan” being useful depends also much on what kind of disaster hits them. For instance what is the “rapid resolution plan” for a bank if all the credit rating agencies turn out to be wrong (again? Suing the regulators for forcing the banks to heed so much the opinions of these risk surveyors?

  13. This is, in fact, a great idea that those in the White House will not support or push to happen. I have lost all faith in the Obama “team” in charge of getting us through the financial travesties which have been visited upon us. They just don’t have the courage to do it. Simple as that.

    This is certainly one thing they can do that would be appreciated by all, and would probably take away a lot of the popular pressure for resolution. Still, they can’t bring themselves to do it. It would reveal too much, and, although it would probably, as Kashyap suggests, be extremely useful as a “financial war game,” to the institutions themselves, it will be fought by them tooth and nail, only because it would promote the transparency that they all so dread.

    The piper, however, will be paid sooner or later, that is a veritable certainty.

    Simon, I so appreciate bringing these things out. A shame that (I believe), so few of the general public are paying attention!!!!

  14. Yes.

    The political problem with the argument about long tails in statistical distributions is that it places the blame on something that can’t be predicted. Thus it’s no one’s fault. When in fact it can be predicted, but it may not be locally rational for any individual to take it into account. Often, I think, this is because those who have the power to change it do not reap 100% of the benefits.

    Consider the energy supply. There are many black swan events that could cause disaster, but if this were to occur, would the oligopolistic energy companies (who have the most direct power to prepare for the black swan event) be harmed? Quite the contrary, they would benefit. They have NO incentive to build robustness into the system.

    The same is true with agriculture. The country has good reason to ensure excess production to guard against catastrophe. But in any given year, sustaining excess production is not rational for farmers. It’s hard to imagine a market-based solution to this problem for many reasons. One is liquidity constraints. Companies that spend lots of money to guard against 200 year events are doomed to be beaten by competitors over any given 20 year stretch.

    It’s hard to imagine a market-based solution that naturally evolves to deal with this.

  15. SJ: “How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup or JP Morgan Chase?”

    Actually, very easily. We could leave most of the company intact (along with many assets that are hard to recreate, like IT infrastructure, call centers, brick-and-mortar banks, etc.) but still punish those responsible by prosecuting individuals directly.

  16. William,
    Good to see you blogging on Simon and James’s excellent site.
    Having just read a precis of the failure of Germany’s Hypo Export Bank – not even regulated as it was held by a holding company and not a financial institution – one’s amazed how such an oversight, despite major concerns by the supervisory authority, BAFIN, failed to raise eyebrows in either Frankfurt or Berlin. Would we call this failure a ‘control fraud’, even though the supervisory body knew what was happening but had no actual powers to deal with the situation.
    Thus the idea of ‘funeral plans’ may actually make businesses think a little more before returning back to the roulette wheel with effectively taxpayers money, never mind depositors money guaranteed by the state.
    Given both Mervyn King and Thomas Hoenig are now averse to the ‘too big to fail’ policies taken by governments in America and Europe, both of course referring to moral hazard, what exactly is to be done to prevent such excessive behaviour in future.
    Given the lack of criminal investigations, or the OCC itself usurping State powers with regards regulating their own internal concerns, should we not direct our attention first at the political system in Washington and power of bankster lobbyist, before enacting legislation, both regulatory and criminal, to prevent such behaviour in future?

  17. I read this piece as saying that Team Obama has created a stealth plan to isolate and write down toxic assets if the ersatz patchwork strategy employed to date fails.
    That they’ve done so is encouraging. It means they know they’re public ‘happy face’ is insufficient to the task of re-ordering the financial markets. Or let’s hope so anyway!

Comments are closed.