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February 7, 2012

Progress on Letting Big Banks Fail

Economix – The New York Times

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The drafters of the Dodd-Frank financial reform law got an important thing right. Despite fierce pushback from the banks — and lackluster support from the White House at critical moments — the legislators communicated a key new intent: megabanks must be able to fail, and the Federal Deposit Insurance Corporation should be in charge of that liquidation process.

The F.D.I.C. was an inspired choice for this role, because it is less captivated by the “magic” of Wall Street and less captured by its money and influence than any other group of officials.

The F.D.I.C. has also long been in the business of shutting down banks while limiting the damage to taxpayers, although it did not previously have complete jurisdiction over the largest banks when they got into trouble. It could only deal with those parts that had federally insured “retail” deposits, and this turns out not to be where the biggest problems have occurred in recent times.

Charged with this mandate involving the too-big-to-fail banks and with the difficult task of potentially shutting one or more of them without disrupting the economy, the F.D.I.C. took the remarkable step of opening up its decision-making process.

By creating a Systemic Resolution Advisory Committee of informed outsiders and by Webcasting the deliberations of that group, the agency has brought perhaps an unprecedented degree of transparency to public policy for banks — a point made forcefully by Dennis Kelleher; his blog at Better Markets is a must-read for anyone who cares about financial regulatory reforms. (Disclosure: I’m a member of the committee, an unpaid position.)

Committee members hold a wide range of views. Some are quite sympathetic to our existing financial structures, some much more skeptical. You can look over the list and make up your own mind as to who is on which side, and you might want to review the recording of the Jan. 25 meeting.

There is no question that the senior leadership of the F.D.I.C. is paying attention to the committee — and at the meetings, key people are put on the spot to discuss all relevant details with well-informed committee members, who can ask a lot of follow-up questions.

It is inconceivable that any other part of our financial regulatory apparatus will ever open itself up in the same way — for example, the Federal Reserve (in both Washington and New York), the Treasury Department and the Federal Stability Oversight Council are likely to be forever opaque. They, too, should open themselves up in public to tough cross-examination by experts, but that goes directly against their aloof and perhaps arrogant culture.

The history of American public administration is littered with examples of policy gone wrong — and actions misdirected — because informed and well-meaning critics were kept at arm’s length. Information is withheld even from other agencies. Powerful special interests work their influence; the rest of society has no effective voice. Even the most energetic Congressional oversight is unlikely to work when expert critics are kept so far from the real policy action.

Within the financial sphere, if the F.D.I.C. really manages to convince the markets that big banks can and will fail — meaning that creditors face the genuine prospect of losses — that changes everything.

Once this kind of failure is a realistic option, there is more pressure for meaningful supervision, because no one wants to be the supervisor in charge when a huge financial institution goes out of business. As was the case with the Lehman bankruptcy examiner report, when a company fails, we really learn who was asleep at which switch.

Are the markets now persuaded that too-big-to-fail is really over? Not yet. As Peter Fisher of BlackRock pointed out at the meeting of the Systemic Resolution Advisory Committee, we should watch for investors demanding a higher return as compensation for the higher risk of actual failure. In other words, the interest rate at which big banks borrow would need to increase — for their holding companies, their operating subsidiaries or both.

The threat of failure for megabanks will be credible only when the F.D.I.C. can convincingly put a firewall around the losses. We need creditors to a collapsing bank to lose the value of their loans — for example, those who have lent to the bank holding company may have some part of their exposure written down and the rest converted to equity.

At the same time, there needs to be a convincing fence, in the sense that one failing megabank must not be able to bring down the rest of the financial system. The threat of liquidation for any big company will be credible only if the damage can be limited to people with direct exposure — otherwise someone at the highest level of government, presumably with the approval of the president, will override all plans and provide a backdoor bailout.

There is always a back door; the point is to make it politically unappealing and economically unnecessary to use it.

The recent failure of MF Global demonstrates that this is entirely possible. Jon Corzine must be one of the best-connected people in the country — few Wall Street financiers are as close to this administration’s power brokers. He placed big bets as if he were still running Goldman Sachs, but MF Global was only about one-twentieth the size.

People who trusted MF Global lost money (and there may have been fraud, which is a different matter and is, one hopes, subject to proper law enforcement action). But the spillover damage to the rest of the financial system was minimal. When Mr. Corzine’s bets went bad, a bailout was not discussed.

The F.D.I.C. is moving in the right direction, although there is much to do before big banks can be treated like MF Global.

Banks must be required to have a financing and legal structure within which losses can be imposed while also allowing for an orderly wind-down of the business. New management and a new board must be brought in under intense time pressure. The failure of an international bank needs ex ante cooperation agreements with other countries, particularly Britain.

Still, in a complex financial system with powerful special interests and myriad global risks, not all of which can be readily quantified, the F.D.I.C. is moving closer to a clear statement of the problem and, at a very granular level, what needs to be done. This is progress.

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