Shoring Up Banks So None Fail

Posted on Tuesday, January 4, 2011

The “too big to fail” problem among banks will be partly fixed in 2011.
Global regulators are expected to reach an agreement that would make a select group of megabanks hold higher levels of capital. That requirement will make them safer, while removing some of the benefit they get from being big. But eliminating the taxpayer guarantee enjoyed by large lenders will require more fundamental measures, which will take years to achieve.
Regulators seem to agree that banks deemed too big to fail are dangerous. Large lenders enjoy implicit government support because of their importance, and as a result, they tend to have higher credit ratings and pay less for deposits and wholesale financing. That, in turn, encourages them to become even bigger and more interconnected.
Broadly speaking, there are two ways to tackle the problem. One is to make big banks less likely to fail. The other is to reorganize them so that they can be allowed to fail without threatening the financial system. In 2011, regulators are likely to concentrate on the first option.
The Basel Committee on Banking Supervision is planning to make large and interconnected banks hold more capital. Most big bank executives believe they will be forced to hold an additional buffer equivalent to at least 3 percent of risk-weighted assets. This will take their minimum capital ratios north of 10 percent, compared with 7 percent for smaller lenders.
The buffer may be in the form of contingent convertible bonds: debt that converts into equity if the bank gets into trouble. However, small countries with large banks may demand even bigger buffers. Swiss regulators have already told UBS and Credit Suisse to lift their capital ratios to 19 percent. Higher capital ratios will make big banks safer, while the cost of the additional equity will offset some of the benefits of cheap financing.
But the approach has flaws. First, it is not easy to spot systemic banks. Lehman Brothers was not particularly large by United States standards. But it was so enmeshed in the financial system that it caused a global crisis.
Second, by drawing up a list of systemic institutions, regulators risk sending a signal that these banks are totally safe — essentially making a commitment to rescue them. That would make the too-big-to-fail problem even worse. Finally, national regulators are bound to interpret the rules differently, creating an uneven playing field.
The alternative is to restructure banks so that they pose less risk. Here — setting aside the draconian idea of breaking them up — there are two broad schools of thought. The first is to force lenders to organize themselves so that they can be wound down safely. This is why regulators have asked large banks to draw up living wills, setting out what they will do if they get into trouble. This could involve selling a business to raise additional capital. It could also involve ring-fencing important bits of the bank, like those that take deposits or process payments, while declaring less systemic parts insolvent.
This is what the Federal Deposit Insurance Corporation already does with smaller lenders. But designing rules to tackle large cross-border banks is harder: it probably requires most of the world’s developed economies to introduce new rules. That will take years.
Meanwhile, some regulators are pushing to introduce mechanisms that will allow them to recapitalize failing banks without winding them down or bailing them out. This approach — known as the “bail-in” option — involves converting a bank’s debt into equity when its capital ratios fall below a certain point. The advantage is that the bank remains intact, while creditors take a haircut and shareholders suffer what Thomas Huertas, of the Financial Services Authority in Britain, calls “death by dilution.”
It is too early to say whether living wills or bail-ins — or some combination — will prevail. As long as the problem remains unsolved, politicians and regulators will remain under pressure to resort to more radical solutions, like an explicit cap on bank size. Privately, regulators hope that the measures they take will eventually prompt big lenders to voluntarily shrink or dissolve into their constituent parts.
What is clear is that just making big banks hold more capital will not solve the too-big-to-fail problem. But it’s probably the best that regulators can hope to achieve in 2011.

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