Here we go again. Major shocks potentially threaten the solvency of some of the world?s largest financial institutions. Concerns grow over the ability of European leaders to shore up their banks, which are reeling from a sovereign-debt crisis. In the U.S., the shares of some large banks are trading at less than book value, while creditor confidence crumbles.
Private conversations among economists, regulators and fund managers turn naturally to so-called resolution powers -- the expanded ability to take over and wind down private financial companies granted to federal regulators by the Dodd-Frank financial reform law. The proponents of these powers, including Tim Geithner and Henry Paulson, the current and former U.S. Treasury secretaries, argue that the absence of such authority in the fall of 2008 contributed to the financial panic. According to this line of thought, if only the Federal Deposit Insurance Corp. had the power to manage the orderly liquidation of big banks and nonbank financial companies, the government could have decided which creditors to protect and on what basis. This would have helped restore confidence, it is argued.
Instead, the government was forced to rely on the bankruptcy process, as in the case of Lehman Brothers Holdings Inc., or complete bailouts for all creditors, as in the case of American International Group. The FDIC already has limited resolution authority, which functioned well over many years for small and medium-sized banks.
Imposing Losses
If it determines that a bank has failed, the FDIC is able to protect retail depositors fully, while wiping out shareholders and imposing losses as appropriate on creditors. But can such powers really be extended to cover the largest banks? And how would this affect today?s unstable situation? The answers are no, and not very well, for three big reasons.
First, the resolution authority under Dodd-Frank is purely domestic -- there is no cross-border dimension. This presents a major problem if large financial institutions, which typically have extensive international operations, need to be shut down in an orderly way. U.S. legislation can?t specify how assets and liabilities in other countries will be treated; this requires an intergovernmental agreement of some kind.
But no international body -- not the Group of -20, the Group of Eight or anyone else -- shows any indication of taking this on, mostly because governments don?t wish to tie their own hands. In a severe crisis, the interests of the state are usually paramount. No meaningful cross-border resolution framework is even in the cards. (Disclosure: I?m on the FDIC?s Systemic Resolution Advisory Committee; I?m telling you what I tell them at every opportunity.)
Preemptive Use
Second, it has never been clear that any government agency would be willing to use such resolution powers preemptively -- before losses grow so large that they threaten to rock the macroeconomy.
The FDIC issued a fascinating paper early this year on how it would have handled Lehman differently if today?s resolution powers had existed in early 2008. If you?d like to think about how resolution works in practice, I highly recommend the paper (see my summary here). But a crucial assumption in it is that the Treasury Department under Paulson would have cooperated with the FDIC, or at least not stood in its way, as it sought to liquidate a troubled, though not yet collapsed, megabank.
I dealt with the Treasury in early 2008 while I was chief economist at the International Monetary Fund. Based on what I saw and heard then, it is hard to believe that Paulson?s team would have supported an early intervention in Lehman.
