The Hopeful Science
The Eternal Life of America’s Megabanks
Simon Johnson
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WASHINGTON, DC – The world economy faces a major problem: the largest banks in the United States 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 Obama administration’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 Senator Christopher Dodd’s financial reform bill, which has passed out of the Senate Banking Committee and will presumably soon be debated on the 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. But in practice 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 $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 Senator 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” (i.e., 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. But there is no such mechanism in place, and there is no chance that one will be created in the near future. Responsible policymakers in other G-20 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 America’s 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 will 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 will you, the beleaguered adviser, urge the president to go? Will 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 will 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 will, 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.
Senator Dodd’s bill, as currently drafted, will 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, a former chief economist of the IMF, is co-founder of a leading economics blog, http://BaselineScenario.com, a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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Nico 05:45 17 Apr 10
Johnson presents with a laundry-list of solutions to the crisis, but his solution is also ersatz. I consistently have to ask myself, why is the Swedish model consistently ignored? That model of temporary or even permament nationalization of the failed banks, is the most efficient solution to this crisis. It retains ALL the functions of the bank intact, but cleans it out from the inside. So why is Johnson presenting us with a clearly fallacious, zero-sum solution? These institutions have become, whether we like it or not, socialized, they are no longer a 'classical firm' that has no market power and whose collapse would not cause any systemic damage. Johnson's adamence to break-up 'too big too fail' is logical, but, as Krugman notes pointless. Why? Banks work in a herd-mentality, as Keynes noted about 'beauty contests'. So instead of having one or two big banks to bail-out, we have twenty-five. What is really needed is, at the very least, a public-option in the financial sector to do what the public-option would have done in the health-care reform, discipline market actors. My preferred option is outright nationalization of systemically important banks.
www.perspectivos.blogspot.com
Mountern 02:56 20 Apr 10
Have anyone consider a cycle of nationalism and denationalism as a solution to financial crises? When financial institutions fail the government will take over everything and pay creditors at market price rates. If there is no market price then the creditors lose everything. By the way there is no such thing as no price. Everything has a price. That includes everyone.
If as a result of the government taking over it leads to other failures, the government will keep doing the same thing with other financial institutions along the line till all the mess is clear up.
This may lead to a situation whereby the majority of the economy is nationalised. So be it. When the dust is settled the government can denationalise at a profit later. Inevitably this denationalisation would result in profits as any value investor will tell you value stocks in the long run can only go up in value but not down. The trick with investment is always cash flow. Government has an advantage in this area.
Effectively, this act is a taxation on the financial institutions that fail as the government would be reaping all the windfalls from buying cheaply in the nationalism process.
Janey 03:35 17 Apr 10
'Big' as in 'influential' - yes, the banks need regulation, inspection, oversight etc. 'Big' as in 'size' - not so much. Banks can be big as long as they are watched very carefully. I'm thinking here of the Canadian example. The US has about 8500 different banks, uncoordinated and seemingly unwatched; Canada has 5 huge banks and two regional banks (all with many branches) that are highly co-ordinated with each other, the govt, and with the regulator.
A very interesting 10minute video interview in the Financial Times with Canada's banking regulator: (3 other parts linked on same page)
http://www.ft.com/cms/8a38c684-2a26-11dc-9208-000b5df10621.html?_i_referralObject=12620477&fromSearch=n