TOO BIG TOO FAIL IS TOO COSTLY TO CONTINUE / THE FINANCIAL TIMES MARKETS INSIGHT ( RECOMMENDED READING )

Too big to fail is too costly to continue

By Thomas Huertas

Published: March 22 2010 18:05

The world is well aware that it needs an exit strategy from the massive monetary and fiscal stimulus that started in the final months of 2008. But we also need an exit strategy from too big to fail. It is simply too costly to continue.

In October 2008 – in the wake of the panic that gripped financial markets following the failure of Lehman Brothers – governments promised that no systemically important institution would be allowed to fail. Governments backed up that promise by recapitalising major institutions. Providing this backstop was just as important as monetary and fiscal stimulus in arresting the slide in the real economy. Instead of the Great(er) Depression, the year 2009 turned into the Great Recession. But, for two reasons, it may be unsustainable for governments to continue to promise that no systemically important institution will be allowed to fail. First, it removes market discipline from such institutions. That increases the probability that systemically important institutions overstretch themselves such that governments will be required to perform on their guarantee. Second, the promise may be unsustainable simply because of the potential expense involved. Even if countries were willing to stand behind these liabilities, they may not find the means to do so.

Arguably, that is exactly what happened in the case of Lehman. The market expected the US government to bail out Lehman. When it did not, chaos resulted. Spreads on bank funding surged. Liquidity contracted and further failures followed. The global economy went into free fall.

So the answer is to get into a position where there is no guarantee, implicit or explicit. We have to move to a point where the market does not expect institutions to be bailed out. That requires an effective resolution regime. It would restore market discipline, so banks pay a risk premium in line with the risks that they take rather than the government support they might obtain.

We therefore need to map out what our long-term resolution policy should be, and consider how we will take steps to move from where we are today to where we need to be. Ideally, we want a resolution policy that allows governments to resolve failing institutions promptly without recourse to taxpayer funds, but at the same time avoids the social disruption that could occur from widespread interruption to deposit, insurance and/or securities accounts. This would allow for maximum continuity in customer-related activities whilst assuring that capital providers remain exposed to loss and avoiding the need to give widespread or long-lasting guarantees of the bank’s liabilities.

To ascertain how we can approach this ideal, the authorities have asked a number of large banks to prepare so-called “living wills”, or recovery and resolution plans. Although it is premature to draw conclusions from this exercise, recommendations are likely to fall under three complementary headings:
1. Change the bank. Identify and perhaps require steps that the institution itself could take under current law and regulation to improve the possibility that it could be resolved by the authorities’ actions, were intervention required, without recourse to taxpayer funds.

2. Change the law. Identify changes in laws and/or regulations that would facilitate resolution methods that do not require taxpayer support. Such changes might include the introduction of special resolution regimes for banks and/or their extension to non-bank financial institutions; the reform of deposit guarantee schemes so that they can pay out insured deposits promptly in the event of a bank failure; the introduction of depositor preference, and/or provisions that would allow the authorities to transform non-core tier one and tier two capital instruments into common equity in the event that the supervisor makes a determination that the bank no longer meets threshold conditions.

3. Charge the firm. If neither of the first two recommendations is feasible, consideration must be given to charging the firm for characteristics of its make-up – such as its size and interconnectedness among institutions – that make a firm systemic. If there is to be a charge, it should take the form of supplemental capital and/or liquidity requirements, for they would strengthen the firm itself. But any such charge should not
be based on a list of systemic institutions. Such a list could be construed to mean that institutions on the list would definitely be rescued rather than resolved, were intervention to be required. That would be – for the reasons outlined above – a recipe for further crises down the road.

We should exit from too big to fail, not perpetuate it.

Thomas Huertas is Vice Chairman, Committee of European Banking Supervisors, and Director, Banking Sector, Financial Services Authority (UK). The views reflected are the personal views of the author

Copyright The Financial Times Limited 2010.