Column: Still too big to fail

Written by Reuters | Updated: Sep 19 2013, 08:24am hrs
Lehman Brothers bankruptcy five years ago crushed the global economy, turfed millions of people out of their jobs and left governments groaning under hefty debt burdens. Since then, policymakers have been beavering away to make sure that a similar calamity never happens again. Measures to address many of the key problems have been taken or are in the works. But if a Lehman went bust today, there would still be havoc.

The main success has been in building up the capital cushions banks have to withstand shocks. Since the end of 2009, the big global banks have increased their shareholder capital by $500 billionthe equivalent of 3% of their so-called risk-weighted assets, according to the Financial Stability Board (FSB), the organisation tasked by the G20 countries to fix the financial system. They are also on track to meet tighter global standards nearly five years ahead of the deadline.

But even this success has to be qualified. The amount of capital banks are supposed to hold depends on the riskiness of their loans. But lenders have too much freedom to decide for themselves how risky a loan is, giving them the opportunity to engage in monkey business. Meanwhile, inside the euro zone, the job of building capital buffers has not been properly done because of a tendency to sweep problems under the carpet. Thankfully, regulators are onto both these issues so theres a reasonable chance theyll be solved.

Less progress has been made in combating the too-big-to-fail problem. If a financial institution is too big to fail, governments have a terrible dilemma: either they let it collapse creating financial chaos; or they bail it out at huge cost to the taxpayer. Five years ago, they tried both methods: Lehman was allowed to go bust but, once they saw the mayhem, governments bailed out the other big institutions that were about to go belly up.

Beefing up shareholder capital should reduce the number of institutions that come close to bankruptcy. But there will always be some that fall through the net. The policymakers plan when this happens is to resolve the bust institutioneffectively winding it down in an orderly fashion.

This, though, is easier said than done. For a start, there need to be laws allowing the authorities to grab failing banks and restructure them over a weekend before panic infects the rest of the financial system. Other creditors also have to be bailed in if there is not enough shareholder capital so taxpayers dont foot the bill. There has been reasonable progress on these principles on both sides of the Atlantic.

Unfortunately, that is not enough if the failing institution is a large complex cross-border group like Lehman. When a bank has operations across the globe, either the authorities in one country need the power to swoop in and restructure the whole operation. Or the authorities in several countries have to swoop in together in a coordinated fashion. Whatever happens, there has to be a legal regime that allows this to occur. This is not yet in place, although the G20 promised to act at its St Petersburg summit earlier this month.

Then, theres the question of complexity. Some financial institutions have such a tangled web of different legal entitiesoften constructed to minimise taxthat it would be impossible to resolve them in a weekend even with the best international collaboration.

The FSBs answer to this problem is for regulators to engage in war-games with their banks to see if they really could be wound down in a crisis. If the regulators discover this cant be done, they are supposed to tell the banks to simplify their structures. But it remains to be seen whether they will have the guts to push through radical structural changes if banks object, as they surely will.

And thats not all. Even if regulators could resolve a complex cross-border institution, doing so could still trigger a panic among other institutions. The main reason for the post-Lehman contagion was that creditors of other banks and brokers ran for the hills fearing they would lose money too. In a resolution, creditors are supposed to suffer losses so there could still easily be a domino effect.

The FSB is finally focussing on this problem. Its solution is to require the big global institutions to have an extra tier of debt capital specifically designed to take a hit if the shareholder capital isnt sufficient. The providers of this bail-in capital will know what they are letting themselves in for and will charge accordingly.

The idea is a good one. If another Lehman was resolved, the holders of bail-in debt in other institutions would, of course, get nervous. But theyd be locked in, so they couldnt run. Other creditors, such as depositors and suppliers of wholesale funding, wouldnt panic because their peers in the bank that had been resolved wouldnt have been hit.

Still, the scheme only works if there is enough bail-in debt. Otherwise, the other creditors in the bank being resolved would get bailed in tooprovoking contagion. At present, banks dont have enough bail-in debt, although the G20 has asked the FSB to come up with proposals to remedy this by the end of next year.

The G20 also said it was committed to maintain the momentum of reform until the job is done. Hopefully, it means it.

Hugo Dixon