Thursday, April 25, 2013

Simon Johnson debunks notion TBTF can fail and refocuses debate on how do we prevent need for resolution

In a Project Syndicate column, Professor Simon Johnson debunks the notion that a Too Big to Fail bank can actually fail by cutting through all of the meaningless assurances by politicians and financial regulators and pointing out that a TBTF could not be resolved (bankruptcy for banks).

So the question becomes, "how do we prevent these banks from failing in the first place?"

The Obama administration's answer to this question was to double down and put the responsibility on the same financial regulators who failed to prevent our current financial crisis.

In case this wasn't a bad enough idea, the Administration and Congress turned over writing the new financial laws that these regulators are suppose to enforce to the bank lobbyists.  The result was the bank lobbyist full employment act, otherwise known as the Dodd-Frank Act.

Regular readers know that I think the Dodd-Frank Act should be repealed with the exception of the Consumer Financial Protection Bureau and the Volcker Rule.  Its sheer complexity reflects the absurdity of trying to replace market discipline with regulations.

Others have answered the question of how to prevent banks from failing by suggesting that the solution is to have them hold more capital. The logic behind this answer is if banks hold more capital it is harder for them to fail as they have more capital to lose.

This logic assumes that banks will not change their risk profile as a result of having to maintain a higher capital level.  But how will anyone know if they take on greater risk until ....

Which brings me to my preferred solution: transparency.

By making the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, transparency subjects the banks to market discipline.

For example, transparency achieves what the Volcker Rule tries to accomplish in ending banks taking proprietary bets.  As demonstrated by Jamie Dimon and JP Morgan's London Whale trade, banks fear that if their bets are known the market will trade against them.  Transparency makes this nightmare an everyday reality if they engage in proprietary bets.

For example, transparency restrains risk taking.  Market participants adjust the price of their exposures to a bank to reflect how risky it is.  This gives banks an incentive to reduce their risk.

But a great myth lurks at the heart of the financial industry’s argument that all is well. 
The FDIC’s resolution powers will not work for large, complex cross-border financial enterprises.  
The reason is simple: US law can create a resolution authority that works only within national boundaries. 
Addressing potential failure at a firm like Citigroup would require a cross-border agreement between governments and all responsible agencies.
On the fringes of the International Monetary Fund’s just-completed spring meetings in Washington, DC, I had the opportunity to talk with senior officials and their advisers from various countries, including from Europe. I asked all of them the same question: When will we have a binding framework for cross-border resolution?
The answers typically ranged from “not in our lifetimes” to “never.” 
Again, the reason is simple: countries do not want to compromise their sovereignty or tie their hands in any way. Governments want the ability to decide how best to protect their countries’ perceived national interests when a crisis strikes. No one is willing to sign a treaty or otherwise pre-commit in a binding way (least of all a majority of the US Senate, which must ratify such a treaty).
As Bill Dudley, the president of the New York Federal Reserve Bank, put it recently, using the delicate language of central bankers, “The impediments to an orderly cross-border resolution still need to be fully identified and dismantled. This is necessary to eliminate the so-called ‘too big to fail’ problem.”
Translation: Orderly resolution of global megabanks is an illusion. As long as we allow cross-border banks at or close to their current scale, our political leaders will be unable to tolerate their failure.

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