The Dallas Federal Reserve Bank on TBTF

Here is the Dallas Fed’s report that argues for breaking up the large banks in order to end “too big to fail.”  Very interesting reading.  My view (blogged about before) is that it is not enough to break up the large banks.  A sector that is critical and comprised of many small firms is not immune to the TBTF problem.  If banks all do a similar activity and are exposed to similar risks, then they all go under in response to the same losses in the same state of the world and the sector needs bailing out.  No firm is too big to fail, but if the sector just is too important to fail, then the concern is similar exposures as much as size.  That said, there is still an advantage to breakup, which is that the worst offenders can be allowed to fail, which may push the crowd back somewhat from the brink.

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Can the Big Fail?

The FDIC has approved an “interim” rule on the orderly liquidation of large financial company here.  Dodd-Frank (Title II) moves on.  According to the law, in the event of the failure of a financial institution whose failure poses significant systemic risks, the FDIC can be made receiver and rapidly impose losses on equity and debt holders.  The idea is that rapid sale of assets can preserve business value, reduce actual bankruptcy (legal) costs (over a billion now for the Lehman bankruptcy), and reduce the uncertainty and illiquidity that affects claims during the bankruptcy process.  This may be a big step in limiting too big to fail.  The legal hurdles however are very large – can this mechanism resolve an incomplete contract in a complex institution without a big fight?  I would rather we never find out.

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The FCIC meets Bernanke on Too Big To Fail

No, the FCIC is not reviewing the book.  Instead, its tackling the topic with its preliminary report on the question that many find Too Big To Answer: what do we do so that firms can fail or how do we stop them taking advantage of the fact that they can’t?  Here is the report.  Very interesting reading.  And I post it along with the link to Bernanke’s testimony before the FCIC yesterday, which, as always, is both clear and deep.  A nice quote:

Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.

And on the new strategies to address TBTF: 1) new Basel capital and liquidity regulations, 2) improve the ability to rapidly resolve/liquidate a large firm, and 3) greater systemic resilience through for example  transparency (clearinghouses and exchanges instead of OTC, penalizing corporate complexity).

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Ending Too Big to Fail

Finally, the two parties have agreed on legislation that largely ends “too big to fail.”  The latest amendment to the financial reform legislation, sponsored by Senators Dodd and Shelby, is described by Dodd here.  My view is that this amendment does end too big to fail and dramatically reduces taxpayer exposure to large failing financial firms. The legislation allows large financial institutions to be taken over and run and liquidated in an orderly fashion by the government when they become insolvent. All shareholders and creditors will take losses in proportion to what they would have taken had the firm been allowed to fail.  It limits section 13(c) of the Federal Reserve Act so that the Fed can only use its emergency lending to lend to solvent institutions (My understanding was that this was pretty much the Federal Reserve’s interpretation of their authority during the initial phases of the crisis and that this interpretation is why Lehman was allowed to go under.  However, as the crisis evolved post-Lehman, the Fed relaxed its interpretation because the size of the “emergency” made the strict interpretation of “lending” as opposed to bailing out less relevant – see Maiden Lanes I through III.)

My two concerns? The legislation seems to be a field day for lawyers in the wake of any such failure.  I would prefer legislation that requires such institutions to have covenants in place ex ante that specify relative losses across debt classes when an institution fails. Second, I fear the complete stripping of an institution before it goes under, which would leave all creditors and equity with nothing but potentially leave the government either needing to cover some of those losses which “somehow” appear to be held in systemically important places or having to cover some commitments of the defunct firm to maintain faith in the financial system. This is related to my view that derivatives contracts allow firms to make new debt senior to existing debt and to pledge value out of firms ‘expropriating’ long-term debt holders and now potentially the taxpayer. Your thoughts are welcome . . .

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Too Big To Fail But Not Too Big To Regulate

The FDIC is modifying the measurement tools it uses to assess the risks that large banks pose. The FDIC currently places each bank in one of four categories of riskiness. This assignment is based on supervisory ratings and capital levels, and is used directly to price deposit insurance but more generally to regulate and evaluate banks’ solvency/riskiness/capital adequacy. Moving forward, the FDIC plans to

draw finer distinctions among large institutions based on the risk that they post.

But more importantly, it changes some of the inputs for the assessment so as

. . . to better capture risk at the time an institution assumes the risk, to better differentiate institutions during periods of good economic and banking conditions based on how they would fare during periods of stress or economic downturns, and to better take into account the losses that the FDIC may incur if an institution fails.

That is, the assessment will be more forward-looking and reign in risk taking more in booms than in recessions. And, if the FDIC cares not only about how much money its insurance fund might lose but what the state of the world is when this happens — meaning are lots of other banks failing at the same time – then this approach will also pay more attention to systemic risk than individual risk. Finally, the FDIC approach will differ for institutions that are simply very large and those that are “structurally and operationally complex or that pose unique challenges and risks in case or failure.” All very good steps forward. The full details are here.

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Avoiding the Next Crisis

When I was a young I worked for a firm in Hyderabad that manufactured and distributed explosives. A major concern of our firm was safety; if something could go wrong it would go wrong. That led to keeping each unit-operation small even though there are obvious scale economies in the explosives business. My experience in India, and witnessing several tragic incidents, reinforced the soundness of these principles. In what follows, John Boyd and I argue that the same principles hold true for banks. The social costs resulting from one incident at a large unit, or a group of connected units, can be catastrophic. R. Jagannathan

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What Caused The Current Financial Mess and What Can We Do About It?

A. Causes

1.  Bank Regulation Broke Down

© Beth Cravens (cravensworld.wordpress.com)

All firms are bound to make mistakes and those mistakes will be bigger the bigger the firms involved.  When big firms also happen to be financial institutions, especially banks, everyone in the economy will pay for their errors.  That is because financial institutions are intricately connected with every aspect of the economy and they can and will bring an economy to a grinding halt if they cease to function. If banks and other intermediaries suffer badly enough, economic activity freezes and the entire economy suffers also.  This is what economists call a “negative externality” and the Great Depression was a great example of what that means in practical terms. It is why banks have always been more heavily regulated than other firms, and why they should be treated the same today. Big banks present special problems and they require special handling.

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