Nouriel Roubini's Global EconoMonitor

Too-Big-To-Fail: Regulatory Reforms of Systemically Important Institutions

Although the G20 finance ministers pledged stronger prudential regulation and financial oversight of systemically important firms at their September meeting, there is no consensus yet among regulators, lawmakers and academics on how best to proceed. Nouriel Roubini noted recently that the problem of banks being too big to fail is even bigger now than it was before the crisis: “Why don’t we go to a system where they’re not too big to fail to begin with? The true solution to the too-big-to-fail problem requires more radical choices. In addition to an insolvency regime, such institutions should be broken up and unsecured creditors of insolvent institutions should have their claim automatically converted into equity. A separation of commercial banking and risky investment banking should also be considered. Thus, some variant of the Glass-Steagall Act should be reintroduced.”

If the government creates a new firewall between deposit-taking institutions and investment banks, as was the case before the repeal of the 1935 Glass-Steagall Act in 1999, only the former group would receive access to lender of last resort facilities and deposit insurance. The latter should be subject to receivership should they get in trouble. Advocates of this solution include Paul Volcker (who chaired the Group of 30 report), Mervyn King (Governor of the Bank of England), and even Alan Greenspan favors a breakup, according to recent statements (although he supported the repeal of Glass-Steagall). Among policymakers, King has made a particularly forceful case, noting that “it is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place.”

Others argue that in the era of financial innovation, size by itself is not the main issue, but rather the degree of complexity and interconnectedness (this was the rationale given for bailing out smaller institutions like Northern Rock in the UK and Bear Stearns in the U.S.). The solution, according to this view, entails stricter capital, liquidity, compensation and counterparty risk management requirements for designated institutions to set the proper incentives against excessive risk taking, including explicit insurance premiums against systemic risk. The Obama administration’s proposal and the updated Turner Review in the UK are in this camp, as are many academic advisory groups (see e.g. NYU Stern report, CEPR/Geneva Report, as well as the de Larosiere report in the EU). Charles Goodhart, co-author of the CEPR/Geneva report, recently made the case against ‘narrow banking,’ citing the pro-cyclical boundary problem of deposit flows in and out of narrow banks as one issue, and the maintenance of credit flows as a second. Similarly, some point to the need to “reevaluate the priority treatment of qualifying repo and swap contracts to determine if it unnecessarily adds to systemic risk” (Squam Lake Working Group on Financial Regulation).

Meanwhile, as regulators and lawmakers on both sides of the Atlantic deliberate, the European Commission’s Competition Commissioner Neelie Kroes has taken action in a move that effectively settles the debate from a practical perspective. On October 27, 2009, she ordered the split of ING, the Dutch bancassurance conglomerate that received bailout funds and was consequently determined to have been given an unfair advantage under State Aid rules. As expected, a few days later government aid recipients RBS and Lloyds of the UK reached an agreement with the government and the EU competition authorities calling for significant divestments of the banks’ businesses over four years, as well as revised Asset Protection Scheme (APS) participation terms for RBS. (Lloyds will not participate in the APS but pay a compensation fee to the Treasury for the implicit protection received so far.) Meanwhile, the UK Treasury will inject £25.5 billion of capital into RBS, for a total of £45.5 billion pounds—the costliest bailout of any bank worldwide, according to press reports.

In the U.S., on the other hand, the House Financial Services Committee presented a draft law on October 27, 2009 based on the administration’s June 17, 2009 proposal for comprehensive regulatory reform. The draft law conveys broad supervisory powers of designated systemically important institutions to the Federal Reserve Board. In addition to higher risk-based capital requirements, the new prudential standards for systemic institutions include leverage limits, liquidity rules, concentration limits and the drafting of a “living will” (i.e. a resolution plan). The Fed also receives authority to ask any systemically important firm to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities or to impose conditions on business activities. Rep. Barney Frank also agreed to a Financial Company Resolution Fund (FCRF) to be pre-funded through risk-based assessments of all financial institutions with US$10+ billion in assets. However, in a sign that a final agreement is still far agreed upon, the Senate Committee is preparing an alternative bill that would consolidate the current four bank regulators into a single supervisory body in a move that would significantly curtail the Fed’s authority. Similarly, according to this alternative proposal, the Fed would be one among equals in the Council of Regulators whose task is to monitor systemic risk.

Once the roles are assigned, the regulator has to decide on the exact quantity and composition of the new capital requirements. Since the adoption of a certain ratio is somewhat artificial and not very indicative as an early warning system—as the recent crisis has shown—economists are advocating market indicator-based contingent debt to equity swaps as an efficient restructuring tool for large institutions that wouldn’t put taxpayer money at risk or trigger derivatives contracts. Nonetheless, Mervyn King cautions that while the inclusion of convertible debt in capital requirements is worth a try, this tool does nothing to address the moral hazard of designated TBTF institutions. On the contrary, “they still have an incentive to take really big risks because the government would provide some back-stop catastrophe insurance.”

Ultimately, if the realized asset value shrinks below liabilities, an orderly resolution would be warranted. The House draft bill appoints the FDIC to the task. In the UK, the FDIC served as a role model to the UK’s new Special Resolution Regime, instituted in the aftermath of Northern Rock. Many other European countries lack an equivalent mechanism, making the timely resolution of cross-border institutions a very difficult task, especially with respect to fiscal burden-sharing (as the example of Fortis showed). Martin Čihák and Erlend Nier of the IMF review the legal framework in the EU and note that while the 2001 Directive on Reorganization and Winding-Up of Credit Institutions explicitly grants the home country that issued the banking license the sole power to initiate reorganization measures with full effect throughout the EU, these principles do not apply to (wholly-owned) subsidiaries that have their own licenses but whose operating systems are nonetheless fully integrated. Indeed, most cross-border expansion in the EU happened through subsidiaries. What is needed, then, is the institution of a special resolution regime at the holding level for cross-border banks on a fully consolidated basis, or at least some harmonization of rules at the state level.

7 Responses to “Too-Big-To-Fail: Regulatory Reforms of Systemically Important Institutions”

PeteCANovember 4th, 2009 at 9:17 am

These banks are not going to give up their highly leveraged trades just because the “spectators on the sidelines” moan and whine about risk. As far as they are concerned, that’s all we are. Just spectators on the sidelines.They do these trades because it’s a major profit maker for them. And because they are hooked in the trading mentality – they all truly believe they are the Masters of the Universe when it comes to trading. So they are not going to quit … unless absolutely forced to do so. Or until the global financial system collapses completely.It reminds me of an old line from William Shakespeare: They are taking “the primrose path to the everlasting bonfire”. These banks are going to keep dancing down the primrose path until they cause a complete collapse of the derivatives system.PeteCA

ArmchairNovember 4th, 2009 at 11:14 pm

Somehow re-introducing Glass-Steagal in “some form” is impossible, because it belongs to a bygone era. It has been written off as some antique from the 1930’s that can’t operate in an era of super-computers.Instead, policy makers are contorting themselves to make up a thousands of mini-solutions that will never accomplish what one semi-elegant solution would have.

eparisiNovember 5th, 2009 at 5:01 pm

Paul Volcker rejects Glass-Steagall IIBy John GapperPublished: November 5 2009 02:00 | Last updated: November 5 2009 02:00John Gapper: Perhaps Paul Volcker is not so keen on Glass-Steagall after all.I listened to the former chairman of the Federal Reserve at a conference in Florida yesterday and thought he might be softening his stance a bit.Mr Volcker was one of the original voices calling for some division of risky financial activities from commercial banking, a division he himself compared to the 1933 Glass-Steagall Act, which split banking from securities underwriting in the US.However, he emphasised yesterday that he was “not proposing a return to Glass-Steagall” because he regarded securities underwriting as “a reasonable banking function analogous to lending”. Nor did he want to bar banks from mergers and acquisitions advice.The only activities he believed should be split out by legislation or regulation from commercial banks were hedge fund and private equity fund management and proprietary trading. Banks should be able to do “whatever Goldman Sachs and Morgan Stanley did in 1980”.As a matter of history, I am not sure this is accurate since Goldman had an arbitrage trading desk – where Robert Rubin made his name – many years ago.I also wonder whether allowing the merging of investment banking and commercial banking goes against Mr Volcker’s own analysis of what went wrong. As he put it:”Commercial banks became much more complicated and adopted lots of functions that sit within capital markets . . . more complex, more complicated, more opaque, more difficult to manage and also bigger.”Today, Mr Volcker did not sound much at odds with Tim Geithner, the Treasury secretary, and the rest of the administration. Indeed, he said he believed the latest version of financial reform put forward by the US Treasury could prevent banks getting too big.But the best moment of Mr Volcker’s talk was when he forgot the name of the Economic Recovery Advisory Board, the body he chairs.

eparisiNovember 6th, 2009 at 9:41 am

John Reed Says `I’m Sorry’ for Glass-Steagall Repeal, Building Citigroup Nov. 6 (Bloomberg) — John S. Reed, who helped engineer the merger that created Citigroup Inc., apologized for his role in building a company that has taken $45 billion in direct U.S. aid and said banks that big should be divided into separate parts.“I’m sorry,” Reed, 70, said in an interview yesterday. “These are people I love and care about. You could imagine emotionally it’s not easy to see what’s happened.”Citigroup was formed in 1998 when Citicorp, a commercial bank, combined with Sanford I. Weill’s Travelers Group Inc., which owned the investment firm Salomon Smith Barney Holdings Inc. The New York-based company lost $27.7 billion in 2008 and took $118 billion in writedowns. Now 34 percent-owned by the Treasury Department, Citigroup sought help in the wake of a credit freeze that claimed three of Wall Street’s biggest firms and led to the deepest recession in 70 years.Congress’ overhaul of U.S. financial regulations should include ordering banks to hold more capital, ensuring executives’ compensation is aligned with long-term profitability and banning firms that take deposits from also engaging in equities and fixed-income trading, Reed said.“I would compartmentalize the industry for the same reason you compartmentalize ships,” Reed said in the interview in his office on Park Avenue in New York. “If you have a leak, the leak doesn’t spread and sink the whole vessel. So generally speaking you’d have consumer banking separate from trading bonds and equity.”Glass-Steagall RepealLawmakers were wrong to repeal the Depression-era Glass- Steagall Act in 1999, Reed said. At the time, he supported overturn of the law, which required the separation of institutions that engaged in traditional customer banking services from those involved in capital markets.“We learn from our mistakes,” said Reed, who wrote an Oct. 21 letter to the editor of the New York Times endorsing a division of banking activities. “When you’re running a company, you do what you think is right for the stockholders. Right now I’m looking at this as a citizen.”Reed headed Citicorp for 14 years until the merger with Travelers. The deal created the world’s biggest financial company in a stock swap valued at about $85 billion. Reed and Weill were co-chairmen and co-chief executive officers until Reed’s retirement in 2000.Citigroup spokesman Stephen Cohen declined to comment.Reed’s CompensationFrom 1997 to 1999, Reed received salary and bonuses totaling $23.4 million, according to Citigroup filings. In 2000, he received a retirement bonus of $5 million, filings show. Citigroup provides him with an assistant and a New York office, for which he pays taxes, he said.The third-largest U.S. bank, Citigroup shed about $300 billion in assets, or 13 percent of its total, in the third quarter and is selling what it calls non-core properties, according to regulatory filings. The company said yesterday that it will spin off its Primerica Financial Services subsidiary.CEO Vikram S. Pandit has eliminated about 100,000 jobs since late 2007, reducing the headcount by 26 percent as of Sept. 30.Citigroup pioneered the production of collateralized debt obligations, bundles of loans whose cash flows were sold to investors. When subprime mortgage borrowers began defaulting on payments in 2007, the CDOs lost value and became part of Citigroup’s $118 billion in writedowns and credit losses.In the last year, the bank received $45 billion from the U.S. government to bolster its capital and another $300 billion in loss guarantees. The Treasury Department retained its 34 percent stake after converting a portion of the $45 billion in rescue funds to equity.

Richard DorfmanNovember 9th, 2009 at 3:12 pm

Impact of the Repeal of Glass-Steagall on The Global Economy:There are a number of countries (including China) that still maintain strict barriers between banking divisions. They were originally thought to be at a competetive disadvantage, but in the end Glass-Steagall just protected the American banks from themselves until it was repealed.The temptations and conflicts of interests associated with the appeals destroyed the true credit analysis required for large M&A deals and investment banks shot themselves in the foot over greed.The repeal of Glass-Steagall provided American investment banks with the means to cheat and the moral hazard issues associated with Too Big Too Fail, creating a bubble doomed to burst. This regulation should be restored immediately.

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