By Simon Johnson. Links to the articles mentioned below are available here: http://economix.blogs.nytimes.com/2011/04/28/the-problem-with-the-f-d-i-c-s-powers/
Under the Dodd-Frank financial reform legislation (Title II of that Act), the Federal Deposit Insurance Corporation (FDIC) is granted expanded powers to intervene and manage the closure of any failing bank or other financial institution. There are two strongly-held views of this legal authority: it substantially solves the problem of how to handle failing megabanks and therefore serves as an effective constraint on their future behavior; or it is largely irrelevant.
Both views are expressed by well-informed people at the top of regulatory structures on both sides of the Atlantic (at least in private conversations). Which is right? In terms of legal process, the resolution authority could make a difference. But as a matter of practical politics and actual business practices, it means very little for our biggest financial institutions.
On the face of it, the case that this resolution authority would help seems strong. Tim Geithner, the Treasury Secretary, has repeatedly argued that these new powers would have made a difference in the case of Lehman Brothers. And a recent assessment by the FDIC provides a more detailed account of how exactly this could have worked (“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd Frank Act,” FDIC Quarterly, Volume 5, No.2, 2011.)
According to the authors of the FDIC report, if its current powers had been in effect in early 2008, the agency could have become involved much earlier in finding alternative – i.e., non-bankruptcy related – ways to “solve” the problem that Lehman Brothers had very little capital relative to likely losses and even less liquidity relative to what it needed as markets became turbulent.
The FDIC report lays out a series of steps that the agency could have taken, particularly around brokering a deal that would have involved selling some assets to other financial companies, such as Barclays, while also committing some funding to remove downside risk – both from buyers of assets and from those who continued to own and lend money to the operation that remained. In extremis, the FDIC argues that it could have handled any ultimate liquidation in a way that would have been less costly to the system and arguably better for creditors (who will end up getting very little through the actual court-run process.)
But there are two major problems with this analysis: it assumes away the political constraint and it ignores the most basic reality of how this kind of business operates.
At the political level, if you wish to engage in alternative or hypothetical history, you cannot ignore the presence of Hank Paulson, then Secretary of the Treasury. Mr. Paulson steadfastly refused, even in the aftermath of the near-collapse of Bear Stearns, to take any proactive or preemptive role with regard to strengthening the financial system – let alone intervening to break-up or otherwise deal firmly with a potentially vulnerable large firm.
For example, in spring 2008 the International Monetary Fund – where I was chief economist at the time – suggested ways to take advantage of the lull after the collapse of Bear Stearns to reduce downside risks for the financial system. Compared with the hypothetical variants discussed by the FDIC, our proposals were modest and did not involve winding down particular firms. Perhaps in retrospect we should have been bolder, but in any case our ideas were dismissed out of hand by the Treasury Department.
Senior Treasury officials took the view that there was no serious systemic issue and that they knew what to do if “another Bear Stearns”-type situation developed – it would be rescue by another ad hoc deal, presumably involving some sort of merger. (Bear Stearns, you may recall, was taken over by JP Morgan Chase at the 11th hour, with considerable downside protection provided by the Federal Reserve.)
Mr. Paulson was very influential given the way the previous system operates and his memoir, On The Brink, is candid about why: he had a direct channel to the president, he was the most senior financial sector “expert” in the administration, and he chaired the President’s Working Group on Financial Markets. Under the Dodd-Frank Act, however, he would have been even more powerful – as chair of the Financial Systemic Risk Council (FS0C) and as the person who decides whether or not to appoint the FDIC as receiver.
It is inconceivable that the FDIC could have taken any intrusive action in early 2008 without his concurrence. It is equally inconceivable that he would have agreed.
In this respect Mr. Paulson was not an outlier relative to Tim Geithner or other people who are likely to become Treasury Secretary. The operating philosophy of the US government with regard to the financial sector remains: hands-off and in favor of intervention only when absolutely necessary.
In addition, as a senior European regulator pointed out to me recently, the idea that any agency from any one country can handle a “resolution” of a global megabank in an entirely orderly fashion is quite an illusion. Similarly, the same person argued, even if we had agreement across countries on how to handle resolution when cross-border assets and liabilities are involved (which we don’t), it would be a major mistake to assume that such resolution would really be without systemic consequences.
These financial firms are very large – more than 250,000 employees in Citigroup currently, operating in 171 countries and with over 200 million clients (according to Citi’s website). The organizational structures involved are very complex – it is not uncommon to have several thousand legal entities with various kinds of interlocking relationships.
Sheila Bair, head of the FDIC, has herself pointed out that “living wills” for such complicated operations are very unlikely to be helpful (see “Bair eyes tougher rules for big banks,” Financial Times, April 18, 2011). Perhaps if the financial megafirms could be simplified, resolution would become more realistic. But any attempt at simplification from the government would need to go through the FSOC and here Treasury has a decisive influence.
And the market has no interest in pushing for simplification – anything that makes it harder to resolve a big bank, for example, will increase the probability that it will receive a “too big to fail” subsidy of some form in the downside scenario. Many equity investors like this kind of protective “put” option.
FDIC-type resolution works well for small- and medium-banks and expanding these powers could help with some situations in the future. But it would be a complete illusion to think that this solves the problems posed by the impending collapse of one or more global megabanks.
An edited version 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.