Letting large banks fail
I wrote a column in the Financial Express today about the reform legislation winding its way through the US Congress. I argue that the regulatory goal of making large banks failure proof will not be realized and that it is better to have a policy of letting even large banks fail.
Towards the end of 2008, US policymakers halted the panic phase of the global financial crisis with three simple words: “No more Lehmans.” In the short run, this statement could mean that there would be no more bankruptcies like Lehman – any large financial entity on the verge of failure would be simply bailed out. AIG was the first beneficiary of the new policy.
However, in the long run, the ‘No more Lehmans’ policy can only mean that there would be no more failures like Lehman. Either financial entities should be unimportant enough to be safely left to the bankruptcy courts when they fail, or they should be robust enough to make their failure extremely unlikely.
In this context, the US House of Representatives has passed a comprehensive 1,279-page Financial Reform Bill, but the Bill could change significantly before it is passed by the Senate and becomes law. How effective would this law be in eliminating Lehman-like failures?
First, the new US provisions (as well as the recent Basel proposals at the global level) impose higher capital requirements on financial institutions. While higher capital would reduce the chances of failure, it would not make failures so unlikely that governments can safely promise to bail out any large bank that slips through the cracks. Other elements of the new legislation are, therefore, designed to make it easier to let large institutions fail.
A second key part of the legislation extends the existing resolution mechanism for failed banks to systemically important non-banks and bank holding companies. Under the old law, Lehman could not have been resolved in this manner and while the banking part of Citigroup could have been resolved, the holding company itself (which owned many of the foreign subsidiaries) could not have been.
The new resolution mechanism makes it easier for the regulator to contemplate the failure of a large entity because the messy bankruptcy is replaced by a more orderly resolution process. There is also a provision for a bailout fund (Systemic Dissolution Fund) to facilitate the resolution process, but this fund is to be financed by contributions from the financial industry itself.
The problem with this proposal is that while it avoids bailing out shareholders of a large entity, it actually formalises the bail-out of their creditors through the systemic dissolution fund. It would, therefore, have the perverse effect of encouraging banks to become even larger to exploit this implicit guarantee from the government.
A third key element in the legislation is the reform of the OTC (over-the-counter) derivatives market. Lehman was not spectacularly large in terms of assets and liabilities. The systemic importance of Lehman (and even more so of AIG) came from OTC derivatives.
Lehman was a large dealer in OTC derivatives and AIG was a large counterparty for subprime-related credit default swaps. They were not too large to fail, but were described as too interconnected to fail. Reform of OTC derivatives is intended to prevent this kind of a situation from arising.
The straightforward solution to the OTC derivative problem is to move these derivatives to the exchanges where a central counterparty (the clearing house) collects margins from all participants and assumes responsibility for all trades. Lehman did have a portfolio of 66,000 contracts totalling $9 trillion of interest rate swaps cleared by LCH.Clearnet in London. LCH not only resolved the Lehman default without any loss, but also returned a large part of the margins that it had collected from Lehman.
To understand the difference with the OTC market, suppose that Lehman had sold $100 billion of a certain OTC swap to some parties and bought $90 billion of the same OTC swap from others. Its failure would force all its counterparties to terminate their $190 billion of Lehman deals and establish new contracts with other counterparties. When all these trades are done through an exchange, the clearing house would have to liquidate only the net position of $10 billion, and this is easier because of the margins that the clearing house has collected.
The US law tries to mandate clearing of standardised OTC derivatives, but the proposals are riddled with loopholes that threaten to make them ineffective. First, it does not mandate exchange trading; it only mandates clearing and that too if a clearing house accepts the concerned derivative for clearing. Second, many OTC derivatives lack price transparency and are therefore illiquid. Without a push towards transparency, many derivatives will simply be unacceptable for clearing. Third, minor changes in terms may make a derivative non-standardised and therefore not subject to clearing.
All in all, the 1,000-odd pages of complex provisions riddled with loopholes in this legislation will not make Lehmans sufficiently unlikely in future. I would suggest that ‘No more Lehmans’ is not the correct policy after all. True capitalism is about letting insolvent banks fail, however painful that might be.
Posted at 2:33 pm IST on Wed, 23 Dec 2009 permanent link
Categories: banks, regulation
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