Wednesday, June 13, 2012

Transparency ends the need for large bank living wills to avoid bailouts

In their Wall Street Journal column, Jeffrey Lacker and Gary Stern argue that living wills are necessary if we are to avoid large bank bailouts in the future as it commits the regulators to implementing these living wills should a bank fail.

Regular readers know I think of these living wills as being like chicken soup; they cannot hurt and they might be helpful.

However, there is a much better way to avoid using taxpayer funds to bailout a large bank.  That way is to require the bank to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

With this data, market participants can assess the risk of each bank and exert discipline on management so management does not take risks that result in the bank failing in the first place.
J.P. Morgan Chase's $2 billion in hedging-related losses has been in the news of late. 
Overlooked in much of the commentary, however, is that a sizeable loss at a large bank holding company would not be a public-policy concern were it not for the belief that the creditors of such firms will benefit from taxpayer support in the event of failure.
This highlights the question of whether the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act eliminated "too-big-to-fail"—that is, the expectation of government rescue of large financial institutions. The short and honest answer at this point is that we simply don't know. 
Numerous provisions of Dodd-Frank are aimed at addressing the problem. But the fate of too-big-to-fail depends on what policy makers, regulators and supervisors actually do, and not on what they assert....
Based on our experience with the recent financial crisis, it is clear that policymakers and regulators will adopt the Japanese model for handling a bank solvency led financial crisis.  They will protect meaningless bank book capital levels and as a result, bailout these banks.

The only way to prevent this is with ultra transparency.  With ultra transparency, the regulators cannot attempt to hide the true financial condition of the bank.  Instead, they are under increasing pressure to take action while the bank still retains enough value that there would be buyers for its different pieces.

The living will comes in handy in determining what these pieces should be.
Attempting to write a credible, detailed living will is the only way we can see of restructuring an institution so that it is not too big or too complex to fail.

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