SEPTEMBER 11, 2009
Sizing Up the Big Issue for Banks
By PETER EAVIS
Lehman Brothers' collapse had many terrible repercussions. Perhaps the worst: Governments are now more likely than ever to rescue a firm like Lehman.
Because of the meltdown that followed Lehman's crash, governments feel they have cover to do pretty much anything to avoid a similar bankruptcy. This means all large banks enjoy de facto state protection.
A year after Lehman, politicians and regulators are still groping for ways to deal with this issue. Meanwhile, the large banks that survived are making big profits on the back of the more-explicit taxpayer-backing they enjoy because of Lehman's demise. Can the too-big-to-fail issue be solved?
Reuters
The Treasury's proposed financial-system overhaul recognizes the problem and suggests winding down a failing firm in an orderly fashion with a "special resolution regime." However, the Treasury says this regime could involve providing financial support to an ailing firm to keep it alive. And since such aid could be used to make creditors whole, this response mightn't allow for true failure. As a result, it mightn't deter creditors from funding risky firms.
One potential answer is to set up a clear system for haircutting creditors to financial firms, to inject market discipline into the system.
For example, University of Texas professor Jay Westbrook suggests deposit-insurance-like caps on how much creditors can expect back after a government seizure.
However, when bank creditors fear losses, they tend to look more closely at all lenders, causing credit markets to freeze. Certain reforms could limit such chain reactions. One change might be to force nearly all derivatives trading, and even the repo market, onto centrally cleared platforms.
These platforms would bear losses from a bankrupt firm, and market participants wouldn't fear the losses showing up later at other banks. The evidence for this? Nicole Gelinas, of the Manhattan Institute, notes that the 1995 collapse of Barings didn't trigger a systemic collapse, partly because everyone soon understood that any losses would mostly end up at derivatives exchanges, not counterparty banks.
Still, some think it is somewhat naive to expect governments not to cave in to rescue demands of an ailing firm, even if a tough wind-down regime were in place. Because of this, Simon Johnson of MIT thinks it might be best to address the "too-big" part of the problem and limit bank size. The problems at CIT Group, a medium-size firm, haven't destabilized the wider system, he notes.
Of course, there is a chance that higher capital may be enough to avoid the sort of collapses we recently have seen. Former Federal Reserve Chairman Alan Greenspan points out that, recently, bank borrowing costs began to fall as capital levels rose. He estimates capital should be around 15% of assets -- above current levels -- for markets to fund banks at reasonable cost.
There isn't any political will to downsize banks and too much fear to threaten bankrupting them. Perhaps higher capital is the best taxpayers can hope for.
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