By John Gapper
Published: October 13 2010 20:23
Don’t hold your breath.
On the face of it, this week marked some progress, with the Federal Deposit Insurance Corporation in the US publishing its plans to be able to liquidate large financial institutions in the same way that it deals with small bank failures – swiftly, ruthlessly and effectively.
Meanwhile, European regulators are mulling the idea of “bail-ins” – an alternative to US-style forced liquidation that would involve converting bonds to equity when a bank gets into trouble. They hope that giving themselves “resolution authority” to alter banks’ capital structure would be sufficient to avoid chaotic bankruptcies.
Governments and central banks will definitely have more authority to act by the time the next Lehman or American International Group threatens to fall and take other institutions with it. But will they have the resolve?
In practice, while domestic banks that get into trouble will be seized instantly, the threat to a big international, interconnected one is much less credible. Despite all the work of the past two years, there is little sign of moral hazard being abolished, or even reduced.
Politicians talk of consigning “too big to fail” to history, but investors and rating agencies regard it as alive and kicking. They do not believe that any government would have the nerve or power to close a Citigroup or a Deutsche Bank and transfer its assets to another bank. There is plenty of room for doubt.
In fact, the incentive for the Goldman Sachs’s of the world to get even bigger and more complex, believing it will shelter them from the risks of enforced closure and shareholder losses, is still strong. That is a logical way to exploit the gap between regulators’ aspirations and their powers.
Perhaps it is the realisation that there will not be a unified approach to dealing with bad banks that has soured things. The debate between proponents of US-style liquidations and those of European-style capital bail-ins has become tetchy.
In a well-ordered world, there would be merit in extending the US approach to global banks. Under the Dodd-Frank Act, the FDIC cannot give public money to a troubled bank, but must liquidate it and form a new bank that is, as the FDIC’s new rule puts it, “not saddled with shareholders, debt, senior executives or bad assets” of the old one.
That deals with the moral hazard problem – in fact, it jumps up and down on its grave. US politicians have become so sick of being accused of favouring bankers that they took no chances in drafting Dodd-Frank. The relevant parts are phrased more like a criminal statute than a civil law.
Few people would have any problem with this provided it were practical. But while it might well work on a large, complex financial institution that happened to be confined within US national borders, such beasts are rare. Instead, the Lehman problem – that the US and UK governments fell out as soon as their relationship was tested in battle – remains.
Bill Dudley, president of the New York Federal Reserve, summed it up nicely in a speech in Washington last weekend, arguing that Dodd-Frank “could be very difficult to implement for complex, globally active firms” that operate in “diverse legal regimes worldwide”. In other words, forget it.
This creates an ancillary difficulty – it is useless to possess a fearsome weapon if no-one thinks you will ever fire it. The risk with a US-only liquidation of a large global bank is that it would cause so much chaos to the wider financial system that even the FDIC would balk.
The European alternative is the “bail-in”, which skirts the problem of varying bankruptcy regimes in European countries – never mind other parts of the world – by trying to avoid it. The hope is that troubled banks’ equity could be replenished by forcibly converting unsecured bonds without having to close down the institutions.
It would be less punitive than Dodd-Frank, but it might be tough enough if accompanied by removal of senior executives – both shareholders and bondholders would, after all, suffer losses. The suspicion among US regulators is that it will become an excuse to keep bad banks in business, and will leave the door open to taxpayer bail-outs.
The truth is that neither approach is foolproof, which is why the Swiss approach of imposing high capital requirements on its banks to avoid being forced to make the choice, is clever. The “Swiss finish” includes a layer of “cocos”, bonds that are contractually converted to equity when a bank is under strain.
But regulators cannot go it alone. The best outcome would be for all countries to have clear resolution regimes and for regulators to be able either to liquidate troubled banks and sell the good assets to others, or to impose bail-ins. When a crisis strikes, it is best to have as many options open as possible.
The vital thing is not the precise form of any resolution, but whether regulators have the confidence to act in concert. That would do more to curtail moral hazard than a perfect mechanism that cannot be used.
Copyright The Financial Times Limited 2010.
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