When Too Big to Fail Gets Too Chaotic to Manage
Policy + Politics

When Too Big to Fail Gets Too Chaotic to Manage

Senate Democrats and Republicans agreed last week to scrap a piece of financial regulatory reform — the creation of a $50 billion fund to cover the costs of taking over and liquidating any failing large bank. That was a good step because such a fund is unnecessary and argument over it was holding up the reform debate.

Until Republican leaders decided they had no choice politically but to let the debate go forward, they had incorrectly claimed the $50 billion — which was to be raised by taxing big banks — would be used to bail out rather than shut down a failing institution. Never mind that the bill sent to the floor by the Senate Banking Committee prohibits bailouts, even of large, internationally active institutions that would be on anyone's too-big-to-fail list.

The issue is not how to fund the initial costs of taking over such a large bank. That could be covered with a loan from the Treasury to the Federal Deposit Insurance Corp., which would handle the actual bankruptcy, and be repaid as assets are sold — supplemented, if necessary, by a levy on other large banks. More fundamentally, many economists and banking experts doubt it is possible to have a sufficiently orderly liquidation of a large, internationally active bank without causing a major worldwide financial market disruption.

Reform advocates have a host of proposals intended to prevent the failure of big banks, including capping their size, limiting their activities and insisting on much higher capital levels. But if one were to fail, the government would seize the bank, remove its management, wipe out the shareholders and force unsecured creditors to share in losses. How that would work without disrupting financial markets is an open question.

When Lehman Brothers Holdings declared bankruptcy in September 2008, it was the largest such proceeding in history. Counterparties grabbed whatever assets they could get their hands on. And regulators in countries in which some of the company's scores of subsidiary corporations did business acted to protect the interest of their own citizens rather than acting cooperatively in winding down Lehman’s affairs. The result has been a chaotic 19-month bankruptcy process that is nowhere close to complete.

E. Gerald Corrigan, a managing director of Goldman Sachs & Co. and former president of the New York Federal Reserve Bank, told Congress in February: “Under the very best of circumstances, the timely and orderly wind-down of any systemically important financial institution — especially one with an international footprint — is an extraordinarily complex task. That is why, at least to the best of my recollection, we have never experienced such an orderly wind-down anywhere in the world.”

Meanwhile, a committee at the Bank for International Settlements in Basel, Switzerland--a sort of international central bank for national central banks--is working on recommendations about how to deal with the cross-border difficulties as countries move to reform their financial regulatory laws. That includes suggestions about how stringent higher capital and liquidity requirements should be and how fast they can be implemented. William C. Dudley, president of the New York Fed, warned in a March speech that getting nations to agree to adopt a similar set of national standards for banks in is essential. Without harmonized standards, banking activity would move inevitably to countries “where the standards are more lax,” Dudley said. In areas losing business, that would create political pressure to loosen the new rules, “which would cause the tougher standards to unravel over time,” he said.

Furthermore, the debt crisis that has enveloped Greece and is threatening to spread to Spain, Portugal, Ireland and possibly Italy could delay perhaps for years any agreement on new capital standards. A nearly $1 trillion rescue package announced over the weekend by the European Union calmed the markets and halted the slide of the euro on Monday. Still, the bailout of Greece did not resolve the eurozone’s underlying problem of runaway spending and debt that threatens to spread the financial crisis across the continent and throughout the world. Riots in Athens over the harsh deflationary measures the Greek government plans to impose to qualify for the aid have left investors uncertain whether the plan will work. Some large European banks hold significant amounts of Greek debt, and in their already weakened condition, a default could threaten their solvency. As Willem Buiter, chief economist at Citigroup, said recently, "The choice faced by the French and German authorities in particular is to either bail out Greece or to bail out their own banks."

In this new crisis, everyone is again trying to put out a fire rather than worrying about standards for the future.