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By Simon Johnson Oct 9, 2011 8:05 PM ET
By Simon Johnson Oct 9, 2011 8:05 PM ET
If it determines that a bank has failed, the FDIC is able to protect retail depositors fully, while wiping out shareholders and imposing losses as appropriate on creditors. But can such powers really be extended to cover the largest banks? And how would this affect today’s unstable situation? The answers are no, and not very well, for three big reasons.
First, the resolution authority under Dodd-Frank is purely domestic -- there is no cross-border dimension. This presents a major problem if large financial institutions, which typically have extensive international operations, need to be shut down in an orderly way. U.S. legislation can’t specify how assets and liabilities in other countries will be treated; this requires an intergovernmental agreement of some kind.
But no international body -- not the Group of -20, the Group of Eight or anyone else -- shows any indication of taking this on, mostly because governments don’t wish to tie their own hands. In a severe crisis, the interests of the state are usually paramount. No meaningful cross-border resolution framework is even in the cards.
(Disclosure: I’m on the FDIC’s Systemic Resolution Advisory Committee; I’m telling you what I tell them at every opportunity.)
Preemptive Use
Second, it has never been clear that any government agency would be willing to use such resolution powers preemptively -- before losses grow so large that they threaten to rock the macroeconomy.
The FDIC issued a fascinating paper early this year on how it would have handled Lehman differently if today’s resolution powers had existed in early 2008. If you’d like to think about how resolution works in practice, I highly recommend the paper (see my summary here). But a crucial assumption in it is that the Treasury Department under Paulson would have cooperated with the FDIC, or at least not stood in its way, as it sought to liquidate a troubled, though not yet collapsed, megabank.
I dealt with the Treasury in early 2008 while I was chief economist at the International Monetary Fund. Based on what I saw and heard then, it is hard to believe that Paulson’s team would have supported an early intervention in Lehman.
No Early Action
And given everything we have seen over the past three years, it is similarly difficult to believe that Geithner, who was New York Fed president in 2008, would now support early action in the case of any major U.S. bank holding company.
Third, who would lose money in any potential liquidation? The fundamental premise of the resolution authority is that some creditors could face losses, but they would be imposed in an orderly and predictable manner to avoid undermining confidence and destabilizing the financial system. Any such thinking today seems far-fetched.
To impose losses on creditors who have lent to big U.S. banks would be to create fears similar to those post-Lehman. The presumption in financial markets is that the largest financial institutions are too big to fail. Events and policy actions since the fall of 2008 have reinforced this notion, with Treasury siding with the big banks over how to interpret the Volcker Rule, how much to increase capital levels, and how to proceed at almost every stage of the reform process. Politicians and officials offer plenty of rhetoric to the contrary, but it’s just rhetoric.
Break Up Banks
To make the FDIC resolution powers credible, large banks should have been made small enough and simple enough to fail.
Of course, if we had really done that, we wouldn’t need a resolution authority. When CIT Group failed in the fall of 2009, it had a balance sheet of about $80 billion. There was no bailout, the firm’s debts were restructured, and today it is back in business -- with an appropriately slimmer $48 billion in total assets at the end of the 2011 second quarter.
There were no adverse systemic consequences for the financial system. I’ve talked to many analysts and people active in financial markets, and cannot find any measurable consequences from the CIT failure on the real economy, including on access to credit for their customers, which were small and medium-sized businesses.
First, the resolution authority under Dodd-Frank is purely domestic -- there is no cross-border dimension. This presents a major problem if large financial institutions, which typically have extensive international operations, need to be shut down in an orderly way. U.S. legislation can’t specify how assets and liabilities in other countries will be treated; this requires an intergovernmental agreement of some kind.
But no international body -- not the Group of -20, the Group of Eight or anyone else -- shows any indication of taking this on, mostly because governments don’t wish to tie their own hands. In a severe crisis, the interests of the state are usually paramount. No meaningful cross-border resolution framework is even in the cards.
(Disclosure: I’m on the FDIC’s Systemic Resolution Advisory Committee; I’m telling you what I tell them at every opportunity.)
Preemptive Use
Second, it has never been clear that any government agency would be willing to use such resolution powers preemptively -- before losses grow so large that they threaten to rock the macroeconomy.
The FDIC issued a fascinating paper early this year on how it would have handled Lehman differently if today’s resolution powers had existed in early 2008. If you’d like to think about how resolution works in practice, I highly recommend the paper (see my summary here). But a crucial assumption in it is that the Treasury Department under Paulson would have cooperated with the FDIC, or at least not stood in its way, as it sought to liquidate a troubled, though not yet collapsed, megabank.
I dealt with the Treasury in early 2008 while I was chief economist at the International Monetary Fund. Based on what I saw and heard then, it is hard to believe that Paulson’s team would have supported an early intervention in Lehman.
No Early Action
And given everything we have seen over the past three years, it is similarly difficult to believe that Geithner, who was New York Fed president in 2008, would now support early action in the case of any major U.S. bank holding company.
Third, who would lose money in any potential liquidation? The fundamental premise of the resolution authority is that some creditors could face losses, but they would be imposed in an orderly and predictable manner to avoid undermining confidence and destabilizing the financial system. Any such thinking today seems far-fetched.
To impose losses on creditors who have lent to big U.S. banks would be to create fears similar to those post-Lehman. The presumption in financial markets is that the largest financial institutions are too big to fail. Events and policy actions since the fall of 2008 have reinforced this notion, with Treasury siding with the big banks over how to interpret the Volcker Rule, how much to increase capital levels, and how to proceed at almost every stage of the reform process. Politicians and officials offer plenty of rhetoric to the contrary, but it’s just rhetoric.
Break Up Banks
To make the FDIC resolution powers credible, large banks should have been made small enough and simple enough to fail.
Of course, if we had really done that, we wouldn’t need a resolution authority. When CIT Group failed in the fall of 2009, it had a balance sheet of about $80 billion. There was no bailout, the firm’s debts were restructured, and today it is back in business -- with an appropriately slimmer $48 billion in total assets at the end of the 2011 second quarter.
There were no adverse systemic consequences for the financial system. I’ve talked to many analysts and people active in financial markets, and cannot find any measurable consequences from the CIT failure on the real economy, including on access to credit for their customers, which were small and medium-sized businesses.