Most experts agree that banks – even the largest ones – are considerably safer now than when the financial crisis kicked in. But what happens if trouble comes calling again? Would national and international overseers let them fail?
The dilemma of whether or not to let banks fail has hounded the markets since the financial crisis. Many, including incoming Fed chairwoman Janet Yellen, believe substantial progress has been made in finding an answer.
Yet there is anything but wide agreement that the overseers of the financial markets would – or should – let banks go under. Despite five years of effort to make the world’s biggest banks safe enough to withstand another round of calamity, the uncomfortable truth is that such a goal is still a long way away.
“Certain institutions are too big to fail in a time of crisis,” according to former UK Chancellor of the Exchequer Alistair Darling – speaking, not at the height of the crisis, but in early November.
“In ‘peacetime’ banks might be allowed to fail, like BCCI and Barings, but it’s different now. We are still in a time of fragility, if not crisis,” Darling told IFR. “I can’t see how a government will let a bank fail during such times.”
Indeed, preventing uncertainty – or worse – in the markets remains the top priority for politicians and central bankers alike – even more important than whether or not state monies are deployed to save an individual institution.
Rodgin Cohen, senior chairman of Sullivan & Cromwell and one of Wall Street’s most experienced lawyers, said regulators and politicians still faced a “Hobson’s Choice” between a taxpayer-funded bailout and an increase in systemic risk if a bank was allowed to founder.
Cohen, whose team advised Lehman Brothers, Fannie Mae, Barclays, AIG, JP Morgan and Goldman Sachs at the peak of the crisis, said too big to fail remains a particular problem in the US, in part because the government encouraged larger banks to rescue their peers – essentially giving the state seal of approval to the creation of oversized institutions.
“Take away those rescues – such as JP Morgan’s purchase of Washington Mutual and Bear Stearns, and Bank of America’s purchase of Countrywide and Merrill Lynch – and institutions are smaller than in 2008,” he said.
Nevertheless, many believe that some of the major bank names are still too large – and that the simplest way to fix this issue is to force them to downsize.
“If an institution is too big to fail, then it is too big,” said Tom Stoddard, senior managing director at Blackstone. “Too big to fail still remains a risk, as there remain large, complicated financial institutions whose counterparties would steer clear if they were at risk of failure.”
At her Congressional confirmation hearings, Yellen indicated she, too, would support efforts to cut the size of those banks whose failure would cause distress in the markets.
“Since those firms do pose systemic risk to the financial system, we should be making it tougher for them to compete, and encouraging them to be smaller and less systemic.”
But others insist that size is not the issue. They believe it is more relevant to look at how an institution is funded, how much capital it holds – and, ultimately, how it would be resolved.
“With resolution regimes coming in across Europe and the US, we now have a different way to resolve banks than we did five years ago,” said Wilson Ervin, vice-chairman of the group executive office at Credit Suisse. “The real issue isn’t size – it’s resolvability. That’s much more important.”
Experts point to the effort to force banks to devise so-called “living wills” – plans for how to handle their own demise – as key in this respect.
“Regulators and banks have been focused on improving resolvability, especially for big banks,” Ervin said. “In many cases, I think, big banks are now actually safer than many mid-size institutions. Too big to fail is an unfortunate and distracting phrase.”
Increasingly, of course, resolvability means putting debt-holders on the hook instead of (or at least before) taxpayers. EU leaders have recommended a bank recovery and resolution directive – which is currently progressing through the European Parliament – that recommends that debt-holders are bailed in before taxpayer money is pledged to ailing banks.
This year has seen Dutch bank SNS Reaal, Cyprus’s major lenders and the UK’s Co-operative bank all attempt to bail-in their creditors to provide rescue capital.
“It is surely a move in the right direction that bondholders take the rough with the smooth,” said Darling. “That it can be done shows things are better financially.”
Indeed, regulators are increasingly insisting that bondholders have “skin in the game” when the issue of bank failure arises.
“The Dodd-Frank Act is extremely clear that future rescues of [US] institutions can only be done without putting in taxpayer funds,” said Sullivan & Cromwell’s Cohen. “Instead, management must be replaced – and debt-holders must suffer losses.”
Indeed, CS’s Ervin suggested that a government rescue in the US was now all but impossible.
“If a US bank failed today, is it really plausible to think Congress would vote for a bailout? It’s hard to imagine that we would see any path besides an investor bail-in now,” he said. “You might also see some cases where a voluntary deal is struck with bondholders in advance, in order to avoid a formal resolution being forced on them, as in the Co-op bank situation in the UK.”
Without question, international co-operation – particularly across the Atlantic – remains a major question for regulators seeking to make global banks safe.
“What happens to a large US institution with a big London operation?” said Ervin.
“The Bank of England has said it is happy for the US to resolve such banks, and will ‘stand aside’ so long as legitimate UK interests are protected – for example to ensure that sufficient liquidity or capital is down-streamed to support local UK operations,” he said.
That did not happen when Lehman failed and Ervin said the Bank of England’s position was “fair enough”, with its proviso that it would take control if funds were not getting through.
“Aligning incentives for governments is perhaps even more important than formal agreements,” Ervin said.
“In 2008, one of the big problems was that government treasuries were being asked to contribute taxpayer funds – leading to tough negotiations around so-called burden sharing. That was a big problem in 2008, and something that a private capital bail-in avoids altogether.”
With investors increasingly realising they are at risk, they appear to be doing a better job of playing their part. They have become more discriminating about the investments they make, and more discerning over the kinds of banks in the market.
“There is a dramatic difference in funding costs between banks in 2007 and those after the crisis,” said Simon Samuels, European banking analyst at Barclays. “In 2007 there was virtually no difference between a strong bank like HSBC and a weak one like Anglo Irish. It had been 60 years since a significant banking crisis.”
“Now there is more differentiation in financing costs, for example, between banks in the south and north of Europe. Nowadays bondholders have to assess banks more like equity-holders always have.”
Ervin said this increased level of discrimination was reflected in the market. “The market doesn’t treat the big banks as too big to fail in terms of special spread advantage anymore.”
Board with their jobs
Darling said another improvement was that bank boards were now paying proper attention to what goes on.
“Board members realise they are not just there for the lunch now. They are there to ask serious questions. And it is being realised that it is a big challenge for boards to understand what is going on. Banks are only as strong as the people in charge,” he said.
Bill Rhodes, former vice-chairman of Citigroup and the co-author of a recent G30 report on bank boards’ relationships with supervisors, shares the view that internal supervision is key.
“Capital and liquidity are all-important in ensuring the safety and soundness of banks,” Rhodes said.
“However culture, particularly risk culture, is also of extreme importance. In addition to having a strong management team, it is also essential for these purposes to ensure that boards of directors have strong oversight.”
In the end, the scope of all these changes may have made it unlikely for another crisis to hit – an admittedly daring idea just five years out from the global financial meltdown.
“Practical risk factors have been reduced,” said Sullivan & Cromwell’s Cohen. “Capital levels and liquidity levels are much higher, and supervision is much tighter. Banks are considerably less vulnerable.”
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