The world economy faces a major problem: The largest banks in the US remain “too big to fail,” meaning that if one or more of them were in serious trouble, they would be saved by government action — because the consequences of inaction are just too scary.
This problem is widely acknowledged, not just by officials but by bankers themselves. In fact, there is near unanimity that fixing it is a top policy priority. Even Jamie Dimon, the powerful head of the very large JP Morgan Chase, emphasizes that “too big to fail” must end.
Unfortunately, the administration of US President Barack Obama’s proposed approach to ending “too big to fail” — now taken up by the US Congress — will not work.
The current center of legislative attention is US Senator Christopher Dodd’s financial reform bill, which has passed out of the US Senate Banking Committee and will presumably soon be debated on the US Senate floor. Dodd’s bill would create a “resolution authority,” meaning a government agency with the legal power to take over and close down failing financial institutions.
The bill’s proponents argue that this approach builds on the success of the Federal Deposit Insurance Corporation (FDIC), which has a long track record of closing down small and medium-sized banks in the US with minimal disruption and no losses for depositors. In this context, “resolution” means that a bank’s managers are fired, shareholders are wiped out and unsecured creditors can suffer losses. Essentially, this is a form of bankruptcy, but with more administrative discretion (and presumably more protection for depositors) than would be possible in a court-supervised process.
Applying this process to large banks and to financial institutions that are not formally banks — and that do not have insured retail deposits — sounds fine on paper. In practice, however, there is an insurmountable difficulty with this approach.
Think about the critical moment of decision — when a megabank, like JP Morgan Chase (with a balance sheet of roughly US$2 trillion), may be on the brink of failure. You are a senior decision maker — perhaps the Secretary of the Treasury or a key adviser to the US president — for this is the level at which the plug must be pulled.
You have Dodd’s Resolution Authority and you enter the decisive meeting determined not to save the troubled bank — or, at worst, to save it with a substantial “haircut” (ie, losses) for unsecured creditors. Then someone reminds you that JP Morgan Chase is a complex global financial institution.
The Dodd Authority allows the US government only to determine the terms of an official takeover within the US. In dozens of other countries where JP Morgan operates subsidiaries, branches or other kinds of business, there would be “plain vanilla” bankruptcy — while some governments would jump in with various ad hoc arrangements.
The consequences of this combination of uncoordinated responses would be widespread, scary and bordering on chaos. This is exactly what happened when Lehman Brothers failed in September 2008, and what happened when AIG was taken over by the US government (actually in a resolution-type structure, with losses implied for creditors) two days later.
The existence of a US resolution authority does not help contain the damage or limit the panic arising from a big global bank in trouble. The failure of such a bank could be managed in a more orderly fashion by using a cross-border resolution authority. There is no such mechanism in place, however, and there is no chance that one will be created in the near future. Responsible policymakers in other G20 countries are very clear on this point: No one will agree ex ante to a specific way of handling the failure of any global bank.
At the moment when JP Morgan Chase — or any of the US’ six largest banks — fails, the choice will be just like that of September 2008: Do you rescue the bank in question, or do you let it fail, and face likely chaos in markets and a potential re-run of the Great Depression?
What would the president decide? He or she may have promised, even in public, that creditors would face losses, but on the edge of the precipice, which way would you, the beleaguered adviser, urge the president to go? Would you really argue that the president should leap over the edge, thereby plunging millions of people — their jobs, their homes and their families — into a financial abyss? Or would you pull back and find some ingenious way to save the bank and protect its creditors using public money or the Federal Reserve or some other emergency power?
You would, in all likelihood, step back. When the chips are down, it is far less scary to save a megabank than to let it go.
And of course the credit markets know this, so they lend more cheaply to JP Morgan Chase and other megabanks than to smaller banks that really can fail. This enables the bigger banks to get bigger. And the bigger they are, the safer creditors become — you see where this goes.
Dodd’s bill, as currently drafted, would not end “too big to fail.” As you can infer from the title of my new book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (co-authored with James Kwak), the global consequences will be dire.
Simon Johnson is a former IMF chief economist, a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.
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