Tuesday, October 20, 2009

"Too Big to Fail" Policy (Warning: Long)

One thing I've been noticing is that many commentators on "too big to fail" (TBTF) policy have clearly never read the Obama administration's financial reform proposals, or at least have an extremely poor understanding of what the administration is proposing to do. This is unfortunate, because TBTF policy is an important, albeit complex, topic. It can't be addressed in a snappy op-ed, or by simply saying "make them smaller" (as if size alone is the problem). It requires serious thought on a number of related issues.

This post is my attempt to have the beginnings of a serious discussion of TBTF policy. It's long, since I took about half of my flight to London to write it. But this is a complex issue — there's no getting around that. If you believe that the Obama administration isn't proposing to do anything about TBTF, or if you believe, like Joe Stiglitz, that the administration is proposing to create "institutions too big to be resolved," then I'm sorry, but you've been seriously misled. My aim in this post is to explain what the administration is actually proposing to do about TBTF, and also to explain where I think the administration's proposals have gone wrong, and what I would do differently. If you really think you understand the administration's proposed TBTF policy, then you can probably skip to the next section on "What I would do differently." But I'm pretty sure that even people who consider themselves close observers of financial news don't fully understand the administration's overall TBTF policy.

What the administration is proposing to do about TBTF

The Obama administration is essentially proposing a three-pronged approach to TBTF.

1. Stricter prudential standards for Tier 1 FHCs.

First, the administration is proposing a new category of financial institution: Tier 1 financial holding companies. A financial institution is a Tier 1 FHC if "material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress." So in other words, Tier 1 FHCs are TBTF financial institutions. Tier 1 FHCs would be supervised and regulated on a consolidated basis by the Fed. The Fed would have sole authority to designate Tier 1 FHCs, and, despite the name, any bank or other financial company (not just FHCs) could be designated a Tier 1 FHC.

To mitigate the risks that Tier 1 FHCs pose to financial stability and the real economy, the administration is proposing that Tier 1 FHCs be subject to more stringent prudential standards than regular banks and bank holding companies (BHCs) — including, importantly, higher capital ratios, lower leverage limits, and stricter liquidity requirements. Tier 1 FHCs would also be required to prepare and regularly update a credible plan for their rapid and orderly resolution in the event of distress — a so-called "living will."

2. Resolution authority for BHCs and Tier 1 FHCs.

Subjecting Tier 1 FHCs to stricter prudential standards still doesn't guarantee that no Tier 1 FHC will ever fail, so we still have to figure out what we're going to do if a Tier 1 FHC does fail. Under current law, there is no statutory authority that would allow for the orderly wind-down of a failed nonbank financial institution, such as a bank holding company (BHC) or a Tier 1 FHC. Commercial banks and thrifts are subject to the FDIC resolution authority (the FDI Act), which is significantly more flexible than the Bankruptcy Code, and does allow for the orderly resolution of failed depository institutions. However, virtually all the financial institutions currently considered "too big to fail" are organized as BHCs, which are resolved under the Bankruptcy Code, not the FDI Act.

Allowing a major BHC like Citigroup or JPMorgan to be resolved under the Bankruptcy Code pretty much guarantees that the resolution will be disorderly and highly disruptive to financial markets — just ask anyone who had exposure to Lehman when it failed. That's why the administration is proposing a new resolution authority, modeled on the FDI Act, for BHCs and Tier 1 FHCs. The proposed resolution authority would only be used if a formal "systemic risk" determination is made by the Treasury Secretary, in consultation with the President, and after receiving a written recommendation from the Fed and either the FDIC or the SEC.

To simplify, the proposed resolution authority extends FDI Act-like resolution procedures to BHCs or Tier 1 FHCs. The reason this is so important is that it allows major nonbank financial institutions to fail without causing a complete meltdown of the global financial markets. Under current law, the government's only choices when faced with the failure of a major nonbank financial institution like JPMorgan or Goldman are: (1) allow a disorderly failure under the Bankruptcy Code; or (2) a bailout, using the Fed's Section 13(3) emergency lending powers. The reason the major BHCs are considered "too big to fail" is because everyone in the market knows, especially after Lehman, that the government won't opt for option (1) — the costs are clearly too high — and will instead opt for a bailout. The proposed resolution authority gives the government a third option: allow the nonbank financial institution to fail, but in an orderly manner that insulates the broader financial markets.

Under the proposed resolution authority, Treasury would have the power to place a failed BHC or Tier 1 FHC in receivership or conservatorship (with the FDIC usually serving as receiver or conservator). Treasury, like the FDIC with commercial banks, would also have the authority to provide "open bank assistance" to a failing financial institution, which would include direct loans, asset purchases, and equity injections. The FDIC resolves the majority of failed commercial banks using so-called "Purchase & Assumption" (P&A) transactions, in which a healthy bank assumes certain liabilities of the failed bank in exchange for certain of the failed bank's assets, plus financial assistance from the FDIC in its corporate capacity. Using a P&A is generally the smoothest and least disruptive way to resolve a failed commercial bank. Accordingly, the administration's resolution authority would allow the FDIC to use P&As to resolve failed BHCs and Tier 1 FHCs as well.

The proposed resolution authority would also mimic the FDI Act's treatment of "qualified financial contracts," or QFCs (e.g., derivatives). The receiver would be required to transfer all of the QFCs between a counterparty and the failed institution to a healthy third-party acquirer or a bridge bank, or to transfer no such QFCs. The transfer maintains cross-collateralization, setoff, and netting rights, effectively allowing for the uninterrupted continuation of the contracts. If the receiver doesn't transfer the QFCs within 24 hours of being appointed receiver, then counterparties are allowed to exercise their close-out rights.

The JPMorgans and Goldmans of the world wouldn't be "too big to fail" if there was a way for them to fail without causing a meltdown of global financial markets.

3. Prompt corrective action.

This is, in my opinion, the key to making TBTF policy work. I think the administration blew some important parts of its prompt corrective action proposal, but I'll get to that in the next post. The administration is proposing a prompt corrective action (PCA) regime for Tier 1 FHCs, similar to the PCA regime applicable to FDIC-insured commercial banks and thrifts. PCA essentially allows an institution's regulator to force the institution to undertake progressively more drastic measures to recapitalize itself as the institution's capital ratio declines.

The administration's proposed PCA regime establishes four categories of capitalization for Tier 1 FHCs: (1) well capitalized, (2) undercapitalized, (3) significantly undercapitalized, and (4) critically undercapitalized. At each new level of undercapitalization, the Fed — which regulates Tier 1 FHCs under the administration's proposal — would be required to take progressively more drastic actions to force the institution to recapitalize itself. Here's a summary of the actions required at each level of undercapitalization (for the full PCA requirements, see pp. 24-32 of the administration's Tier 1 FHC proposal):

  1. Undercapitalized:

    • Additional monitoring by the Fed
    • Capital restoration plan
    • Asset growth restricted
    • Prior approval from the Fed for acquisitions and new lines of business
    • Any other action the Fed deems necessary

  2. Significantly Undercapitalized:

    • Required recapitalization or merger
    • Restrictions on transactions with affiliates
    • Asset growth restricted
    • Restrictions on activities deemed excessively risky
    • Management changes
    • Required divestitures
    • Restrictions on senior executive officers' compensation

  3. Critically Undercapitalized:

    • Bankruptcy petition required within 90 days of become critically undercapitalized
What I would do differently

More realistic PCA triggers. First, the prompt corrective action (PCA) regime. The reason I think the PCA regime is the key to TBTF policy is because it makes the new resolution authority for Tier 1 FHCs credible. Some commentators dismiss the resolution authority as a solution to TBTF because they say the market won't believe that the government will actually use it. They say the market will continue to believe that the government will opt for a bailout rather than the new resolution authority. In that case, the new resolution authority wouldn't do anything to fix the moral hazard that TBTF induces — the JPMorgans and Goldmans of the world would still be betting that the government will bail them out, and thus would still have an incentive to take excessive risks. Now, I think those commentators are wrong, and that the government would opt for the new resolution authority over a bailout, even without a PCA regime.

But a PCA regime comes as close as possible to guaranteeing that the government will actually use the new resolution authority. Lehman Brothers was essentially allowed to come careening into bankruptcy court — or, as one former Lehmanite put it to me, Lehman went down with "guns blazing." There was no mechanism to force Lehman to take specific steps to recapitalize itself in the months between Bear's failure and September 15th. All we had was Hank Paulson and Tim Geithner badgering Dick Fuld about raising capital or finding a buyer, which they apparently did, to no avail.

A PCA regime not only minimizes the chances that a Tier 1 FHC will actually fail, but it also prepares a failing Tier 1 FHC for an orderly resolution. Lehman was still transferring assets in between its various European and North American branches at a furious pace right up until its failure. As a result, a lot of hedge funds were very surprised to discover that their assets were not in segregated accounts, but in fact had been transferred to Lehman Brothers International (Europe) and then rehypothecated. This was a significant source of uncertainty in the days following Lehman's bankruptcy filing — it was Knightian uncertainty in action. A PCA regime would prevent this kind of thing from happening, as the Fed would have the authority to restrict transactions between affiliates once a Tier 1 FHC becomes significantly undercapitalized.

So what did the administration do wrong in its PCA proposal? I think the administration focuses too much on capital levels as the relevant measure of a Tier 1 FHC's health. The biggest problem with the PCA regime applicable to commercial banks is that too often commercial banks can go from "well capitalized" to insolvent without ever triggering the PCA requirements. This problem is even worse for Tier 1 FHCs. Lehman had a Tier 1 capital ratio of 11% as of August 31, 2008 — just two weeks before it filed for bankruptcy. Had Lehman been a commercial bank, it wouldn't have triggered the PCA requirements until it was far too late. The administration's proposal requires that the PCA triggers (which it calls "capital standards") include a risk-based capital requirement and a leverage ratio.

I would make the PCA triggers less focused on capital levels, and more focused on the conditions that make Tier 1 FHCs susceptible to modern-day bank runs. For example, I would make one of the PCA triggers contingent on the tenor of the Tier 1 FHC's overall liabilities. As of August 31, 2008, over half of Lehman's $211 billion tri-party repo book had a tenor of less than one week, which made it remarkably susceptible to a run in the repo markets — which, of course, is exactly what happened. Lehman was also relying on roughly $12 billion (at least) of collateral from its prime brokerage clients to fund its day-to-day operating business. These conditions had persisted for several quarters before Lehman's bankruptcy.

The Fed should be required to take prompt corrective action once a Tier 1 FHC allows the tenor of, say, 20% of its overall liabilities, or 50% of its daily funding requirements, to drop below one week. (I just pulled those numbers out of the air, for explanatory purposes; I'd have to get down in the data before I could say what the appropriate tenors should be.) These are the kinds of PCA triggers that would be the most effective. A PCA regime focused on capital levels is unlikely to make much of an impact.

New resolution regime automatically applicable to Tier 1 FHCs. I think the administration makes a big mistake by requiring a separate "systemic risk" determination in order to use the proposed resolution authority for Tier 1 FHCs. This introduces needless uncertainty. Remember, a financial company is a Tier 1 FHC, by definition, if "material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress." An institution thus can't even be a Tier 1 FHC in the first place if it doesn't pose a systemic risk. Why require an additional, albeit slightly different, determination of "systemic risk" before the new resolution authority can be used? This will leave the market guessing as to which resolution regime — the Bankruptcy Code or the new resolution authority? — will be used to resolve a distressed Tier 1 FHC. Creditors, unsure which resolution regime will apply and thus how their claims will be treated, will be less likely extend credit at exactly the time we don't want creditors to be pulling back from a Tier 1 FHC.

I would make the new resolution regime automatically applicable to Tier 1 FHCs. By requiring a second "systemic risk" determination, the administration is essentially saying that there are Tier 1 FHCs that can be resolved in an orderly fashion under the Bankruptcy Code as it's currently written. You'd be hard-pressed to find any market participant who agrees with that statement (in fact, I don't believe Tim Geithner honestly believes that statement). I continue to be confused by the insistence on a second "systemic risk" determination.

Okay, that's all for now — I do, after all, have a day job. I hope this discussion can induce at least some commentators to move beyond simplistic (and completely unrealistic) "break up the banks"-style discussions of TBTF policy.

18 comments:

Anonymous said...

I have a little question. Could there have been a credit crisis without the excessive amount of exotic subprime lending? If your answer is yes, I do not believe you.

Can anybody with a sophisticated economic computer model recreate the credit crisis without the subprime foreclosure wave being the perturbation. If they claim they can, I do not believe them.

TBTF is an ignorant explanation as to why they could not let them fail, and your post is excellent, as usual.

csissoko said...

"I personally don't think the proposed resolution authority can work"
From: http://economicsofcontempt.blogspot.com/2009/04/since-when-is-treasury-under-wait-and.html

Also: http://economicsofcontempt.blogspot.com/2009/03/oh-my-god-nationalization-is-not.html

Precisely because you are so well informed I would like to learn a little about the evolution of your views (if you feel that there has been any) on this issue.

Julia Pappas-Fidica said...

Neither Lehman Bros. Holdings Inc. (the entity which went into bankrupt) nor Bear Stearns were bank holding companies. Investment banks only started becoming BHCs when Goldman and Morgan Stanley applied to the Fed and were approved in Sept. of 2008.

Gene said...

What's the typical distribution of tenors of the repo book? My understanding is that most repo transactions are very very short-term, on the order of a few days to a week. So, was Lehman that abnormal in its dependence on short-term financing?

Dave said...

The P&A proposal seems very sensible.

I don't see why these companies can't be made small enough to mitigate any single entity's systemic risk though. Were we really so much worse off before all those mergers and acquisitions?

Also, I think Anon has a good point there... but how much of the subprime crisis was created by the fact the gov't decided these big companies could absorb the extra risk?

Anonymous said...

Unless you believe in Santa Claus, you can't reduce a society's systemic risk by division.

If you split it into 1,000 companies, the new pop saying would be "too small to fail".

It's a small, intricately interconnected world, and that is not going to change. I sincerely believe that bailouts are the most efficient means of dealing with a systemic crisis. That is why TARP quickly emerged as the answer, and why Bernanke expanded the balance sheet. That is how you save a patient who is about to die of a systemic failure. You get out the big syringes and the big needles and you pump the poor bastard full of antibiotics. It's that or die. If the Muppets creator had a systemic cop on the beat, he would still be creating Muppets. The cop is needed.

Economics of Contempt said...

Anonymous @ 10:06 AM:

No, I don't believe this financial crisis could have happened without subprime. Of course, financial crises in general can happen without subprime mortgages — but I don't think that's what you were saying.

Economics of Contempt said...

csissoko,

It's true that I'm more optimistic about the resolution authority now than I was back in April. Mostly that's because back in April, all we had was Treasury's stand-alone proposal for a new resolution authority, which hadn't yet been combined with the Tier 1 FHC and PCA proposals to form a cohesive strategy. The Tier 1 FHC and PCA proposals weren't released until June. The PCA proposal in particular has the potential to add a good deal of credibility to the resolution authority.

That said, I'm still pessimistic about the cross-border aspect of the resolution authority (which I didn't have time to get into). I think there are some crude ways around this, but I'm not wild about effectively leaving the cross-border issues unresolved.

Anonymous said...

"No, I don't believe this financial crisis could have happened without subprime. ..."

No surprise as you are astounding reality based. I guess what concerns me is most talking heads seem to never mention subprime as being the cause.

And why, within weeks of the President asking for a new way to get minorities approved for housing loans, was there suddenly subprime available everywhere? I do not want to be accused of making too simple a connection, but am I wrong to suggest it suddenly became widely available - no money down and no income verification - because the President of the United States of America, the most powerful man on the face of the earth, asked his Neocon buddies in the financial world to "get'r done."

And keep in mind, the Neocons were so proud of this scheme that they wrote it down in books, and predicted it would result in a 100-year Neocon reich - well, reign. They wanted to create 5.5 million Alphonso Jackson voters.

Why are financial commentators totally missing what happened here? They're seemingly still running around like morons trying to pin it all on Saddam Sachs, the evil doers.

CW said...

I have always thought that Paulson let Bear Stearns and Lehman fail as payback for their refusals to help rescue Long Term Capital Management. Goldman took a lot of losses from their exposure to LTCM. I really do not think that Paulson understood what the full ramifications of his revenge snit.

Human factors are the messiest to resolve.

Marshall said...

I think all of these ideas are problematic from the get-go. The simple existence of institutions that are too big to fail constitutes a failure of policy. Why is it in the public interest to have firms whose failure poses a risk to the economy at large such that my tax dollars ought to be at risk? Do I get an entirely theoretical piece of the upside that supposedly accrues to large financial firms by virtue of their size?

As written, this is a set of proposals aimed at preserving political cover for powerful officials to help their friends (and future employers) out if things get ugly.

The solution to Too Big To Fail is simple. Either don't get too big, or don't fail. So the regulation is "all institutions above size X must maintain equity:debt ratio of Y%." If huge institutions can't base their capital structure on unrealistic projections of returns on risky assets, they won't fail. Bad for profits, of course, but the government's interest isn't in financial industry profits.

Macrojo said...

Excellent post.

Do you think moving a tier 1 fhc below well capitalized could immediately cause a run? I assume systemically important banks would likely be funding a low rates from risk sensitive investor. Any indication of weakness could immedAtely cause a run In the short funding market. Of course the fallout would be limited due to the resolution mechanism, I don't think the pca would eliminate the possibilty of a run

babar ganesh said...

does the fed need to determine and make known before a crisis which institutions are systemically important (tbtf)?

too many krispy kremes said...

The new macro-prudential mantra is "too inter-connected to fail". So there's now a risk management of networks looking at nodes and links in the financial system. Insofar as this produces new and useful information, that can only be good. I doubt it has developed any useful prescriptive powers though.

I think where we're at is a million economists (shades of shakspear) banging away at typewriters trying to find ex post explanations and prescriptions.

Anonymous said...

Can systemic risk be eliminated/better detected and managed by division: smaller financial institutions and partitioned activities?

In my opinion, the answer is no. The more concentrated and less partitioned, the easier it will be to monitor and manage systemic risk and avert the death spiral.

Anonymous said...

Why not just re-instate Glass-Steagall? Why is taxpayer money (via FDIC/TLGP and various liquidity programs) being used to prop up (hahaha) the Goldman prop desk?

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