By Simon Johnson
Back when it really mattered – last spring, during the Dodd-Frank financial reform debate – Senator Ted Kaufman of Delaware emphasized repeatedly on the Senate floor that the proposed “resolution authority” was an illusion. His point was that extending the established Federal Deposit Insurance Corporation (FDIC) powers for “resolving” (jargon for “closing down”) financial institutions to include global megabanks simply could not work.
At the time, Senator Kaufman’s objections were dismissed by “experts” both from the official sector and from the private sector. Now these same people (or their close colleagues) are falling over themselves to argue resolution cannot work for the country’s giant bank holding companies. The implication, which these officials and bankers still cannot grasp, is that we need much higher capital requirements for systemically important financial institutions.
Writing in the March 29, 2011 edition of the National Journal, Michael Hirsch quotes a “senior Federal Reserve Board regulator” as saying:
“Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and settlement systems,” and, “We think we’re going to effectively resolve that using Dodd-Frank? Good luck!”
The regulator’s point is correct. The FDIC can close small and medium sized banks in an orderly manner, protecting depositors while imposing losses on shareholders and even senior creditors. But to imagine that it can do the same for a very big bank strains credulity.
And to argue that such a resolution authority can “work” for any bank with significant cross-border is simply at odds with the legal facts. The resolution authority granted under Dodd-Frank is purely domestic, i.e., it applies only within the United States. The US Congress cannot readily make laws that apply in other countries – a cross-border resolution authority would require either agreement between the various governments involved or some sort of synchronization for the relevant parts of commercial bankruptcy codes and procedures.
There are no indications that such arrangements will be made – or that there are serious inter-governmental efforts underway to create any kind of cross-border resolution authority, for example, within the G20.
For more than a decade, the International Monetary Fund has been on the case of the eurozone to create a cross-border resolution mechanism of some kind within their shared currency area. But European (and other) governments do not want to take this kind of step. Rightly or wrongly, they do not want to credibly commit to how they would handle large-scale financial failure – preferring instead to rely on various kinds of ad hoc and spontaneous measures.
I have checked these facts directly and recently with top Wall Street lawyers, with leading thinkers from left and right on financial issues (US, European, and others), and with responsible officials from the United States and other relevant countries. That Senator Kaufman was correct is now affirmed on all sides.
Even leading figures within the financial sector are now honest on this point. Hirsch quotes Gerry Corrigan, former head of the New York Federal Reserve Bank, and an executive at Goldman Sachs since the 1990s.
“In my judgment, as best as I can recount history, not just the last three years but the history of mankind, I can’t think of a single case where we were able execute the orderly wind-down of a systemically important institution—especially one with an international footprint.”
It is most unfortunate that Mr. Corrigan did not make the same point last year – for example, when he and I both testified before the Senate Banking Committee on the Volcker Rule (in February 2010).
In fact, rather tragically in retrospect, Mr. Corrigan was among those arguing most articulately that some form of “Enhanced Resolution Authority” (as he called it) could actually handle the failure of Large Integrated Financial Groups (again, his terminology).
The “resolution authority” approach to dealing with very big banks has, in effect, failed before it even started.
And standard commercial bankruptcy for global megabanks is not an appealing option – as argued by Anat Admati in the New York Times’ Room for Debate in January. The only people I have met who are pleased with the Lehman bankruptcy are bankruptcy lawyers. Originally estimated at over $900 million, bankruptcy fees for Lehman Brothers are now forecast to top $2 billion (more detail on the fees here).
It’s too late to re-open the Dodd-Frank debate – and a global resolution authority is a chimera in any case. But it’s not too late to affect policy that matters. The lack of a meaningful resolution authority further strengthens the logic behind the need for larger capital requirements, as these would provide stronger buffers against bank insolvency.
The Federal Reserve has yet to announce the percent of equity funding – i.e., capital – that will be required for systemically important financial institutions (so-called SIFIs). Under Basel III, national regulators set an additional SIFI capital buffer. The Swiss National Bank is requiring 19 percent capital and the Bank of England is moving in the same direction.
Yet there are clear signs that the Fed’s thinking – both at the policy level and at the technical level – is falling behind this curve.
This time around, officials should listen to Ted Kaufman. In his capacity this year as chair of the Congressional Oversight Panel for TARP (e.g., in this hearing), Mr. Kaufman has been arguing consistently and forcefully for higher capital requirements.
An edited vesion of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.
The Baseline Scenario 
“Citibank is a $1.8 trillion company, in 171 countries with 550 clearance and settlement systems,”
Have banks made nations irrelevant?
The lack of a meaningful resolution authority further strengthens the logic behind the need for larger capital requirements
And even further strengthens the argument for making TBTF banks outright illegal.
The next financial crises having to do with TBTF’s will be the last! There will be no money in the Fed to orchestrate a bailout, period. As I write, every homeowner in the United States has lost 30%-50% in private home equity. The well has gone dry? Indeed, for the next crises will wipe-out any if not all equity in all America’s homeowner’s nest eggs. You won’t be able to get blood from this stone (that being the poor and middle class) and the country will be sold out from under us,…
JMHO
Thankyou Simon and James :-))
I agree with Nemo. More capital makes it less likely that banks will fail. But, not so much that we can disregard the risk. When banks this size eventually do fail, they will again get a taxpayer bailout–unless, of course, by then they have gotten so big that they are beyond “bailability”. The more sensible approach is to just break them up now and forbid their re-emergence.
The more sensible approach is to just break them up now and forbid their re-emergence.
That’s fine but there is still the age old question of who would take its place, and with what capitol? You literally have to take the candy from the baby, it won’t just hand over the sweets.
Can’t government accomplish resolution/recapitalization through forced conversion of unsecured debt to equity regardless of size/complexity of the financial institution?
@ Richard
My calculations for equity lost from U.S. Homeownership is approx. $13 Trillion +/- 10%. This capital evaporated into thin air in approx. 4-5 years and is “Gone”!!!
The American taxpayers/citizens of the poor, and middle class were literally raped by the world’s Oligarchy!
We as American citizenry, figuratively and literally pay the World’s Military Bill’s…finance their failures on our “Dime”? (We cannot continue to shoulder the rest of the World’s responsibility!)
PS. The Federal Reserve is bankrupting our country. The government can’t accomplish nothing…we must demand it, period!
Quote: James S. Henry…”The Blood Bankers(Basic Books, 2005) Re: “Attack of the Global Pirate Bankers (Page 8/9)”
“In the last thirty years fueled by the globalization of financial services, lousy lending, capital flight and mind-boggling corruption, a relatively small number of major banks, law firms, accounting firms, asset managers, insurance companies and hedge funds have come to launder and conceal $10 trillion to $15 trillion of private untaxed anonymous cross-border wealth.” Fini!
Ref: eg. CitiGroup
http://www.informationclearinghouse.info/article20348.htm
If I’m not mistaken, you imply that this supposed resolution authority or “enhanced” resolution authority was simply a straw man (or is it a stalking horse or even Trojan horse?) to deflect arguments for real reform. Or am I just imputing my opinion to you. I mean, if these institutions could be resolved orderly, there’d be no need to break them up or put other constraints on them. A neat deception at the time.
I mean, if these institutions could be resolved orderly, there’d be no need to break them up or put other constraints on them. A neat deception at the time.
Todays (and yesterdays) theater dictates and demands the exact opposite. As I have stated before, many trains left the stations creating a left behind population. Who are now very confused as to their standing in life, and institutions are no exception.
This is all Maginot Line Thinking!
How does increasing capital function within the TBTF model? In becoming “safer,” do you eventually attain TBTF status? Why do you think that regulation begets oligopolies (beget oligarchs, beget banksters)?
Unless and until risk is differentiated from uncertainty (see: http://readingthemarkets.blogspot.com/2009/10/boyko-were-all-screwed.html), errors of conflation will continue to result in noncorrelative information that produces larger and more frequent boom-bust bubbles. In a world of financial innovation and bubbles, it is uncertainty — not risk — that should be the randomness component of focus.
If this was 1930, Simon Johnson would have said, “The Moon is 400,000 km away and it is impossible to create a vehicle that would escape earth’s gravity to land there”.
Jamie Dimon runs the most succesful bank in the US and has frequently commented on the need for Resolution Authority. This means that it is possible. It is complicated but achievable. Each financial institution is comprised of a number of legal entities, seperately incorporated in different jurisdictions. This myth about interconnectedness is similar to saying that Delta Airlines is too big to fail because they have planes in various locations overseas: complete mickey mouse argument. The assertion would be that Delta will hide its aircraft overseas before it declared bankruptcy. Quite ludicrous!
GM just went through bankruptcy while maintaining various overseas operations. When dealing with a Barclays Bank resolution for example, you would be dealing with Barclays Bank US, Barclays Bank UK etc…these are separate legal entities.
Lehman actually gave us a template and if it cost $2B to wind it down, the next resolution will cost less.
A Resolution Authority must be created. There is no evidence that the efficiencies created by large banks are small enough.
This is all Maginot Line Thinking!
You need to think more along the lines of balancing the scales of capitol justice, the eventual answer to your questions will be integrity. You seem to have a 360 degree mentality, it always comes round full circle, and starts the same thing all over again.
The risk that out weighs the uncertainty is ones ability to raise its own capitol and be free for an eternity, rather than a 100 year renter who tries to pass their wealth to younger and less able siblings. Its not reported or proven but the side effects can most certainly be felt among the masses.
@ The risk that out weighs the uncertainty
If uncertainty, by Knightian definition, is unforeseen and unmeasurable, how do you posit that “risk that out weighs the uncertainty”?
@ the side effects can most certainly be felt among the masses.
Agree totally, but “why?” is the question. I argue that it is a mischaracterization of the underlying economic domain as to predictability, risky, and uncertain regimes.
Bad metrics lead to flawed pricing that create “vapor assets”.
Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift. Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?
Similarly, collateralized debt obligations (CDOs) and credit derivative swaps were the subprime boom’s vapor assets where NINJA mortgagors were given property rights in order to enable questionable securitizations at even more questionable AAA-ratings prices to take place. But when the bubble burst, “questionable” became “improbable” as deterministic metrics lacked robustness to manage uncertain investments.
The next crisis will likely be caused by a seemingly small issue, a al Arch Duke Ferdinand and the ensuing WW1. The Fed and IMF will be powerless to stop the conflagration, and seemingly innocent citizens across the globe will watch their assets go up in smoke. No resolution authority will be enough, and the dollar will loose it’s reserve status. The US has abused it’s currency post, and our standard of living will suffer mightily. Ask Britain what it’s like to be last century’s Economic superpower, cause that’s our future….
@ Desi Girl -DGW
“JP Morgan (Chase) runs the most successful bank in the world”
C’mon Desi Girl, your a bright person. When we[?],I read between the lines we laugh for redundancy…at least I do? But can you honestly believe that JPMC didn’t float the rumors for Bear Stearn’s, and Washington Mutual’s (WAMU) demise. Do some short-term time traveling and take notice that “All Financial Candidates” were on thin (not just these two entities) ice, period! Why BS’s, and WAMU? After all, it was the Federal Reserve that shored up Bear Stearn’s from going into bankruptcy – which basically gave the company away to JPMC as a gift when BS’s capitulated?
Next? Indeed it was the Federal Reserve again that was giving (put on JPMC life support system for optimizing a lagging/foward time trail?) WAMU, $2bn/monthly until (mysterious rumors of insolvency created by deviate counter parties namely JPMC?) they were gobbled up again by JPMC for peanuts?
Collusion with the Fed,Treasury, and Regulators is an absolute axiom when it comes to 21st century “American Oligarchy”, dictatorship of democracy!!!
As do I Earle, laugh that is, I began calling them JP hot pants for their hot investment stragety.
Why not increase taxes on bank debt and reduce taxes on equity held above 7%?
Incentivise banks to hold more capital
$2 billion dollars in bankruptcy expenses is a pittance compared to the financial losses created due to Lehman’s mismanagement/fraud. To the extent that the bankruptcy process achieved the best resolution to the Lehman failure (which is likely), those bankruptcy expenses were money well spent.
One could make an argument about excessive hourly rates for bankruptcy law firms and accountants; but that’s an argument for another day.
If TBTF can’t be ‘resolved’; will it have to be nationalized ?