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.