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The New York Fed’s William Dudley gave a surprisingly candid, meaning not positive, assessment of the state of the Too Big to Fail problem in a speech yesterday at the Clearing House’s Second Annual Business Meeting and Conference. From the text of his speech (hat tip Richard Smith):
Because no plausible level of capital and liquidity standards will be sufficient to reduce the probability of failure to zero, it also makes sense to work on the other major margin—to reduce the cost of the failure of a large, complex financial firm. We can do this by making changes so that such failures are less likely to impair the functioning of the broader financial system. In this area, although many initiatives are in train, I would conclude that we are still very far from where we need to be.
Dudley then tells the audience that there are some constraints in Dodd Frank on the ability of systemically important firms to get bigger (but he’s clearly hoping, rather than certain, that these measures will be effective). He also says the Fed is in the process of mapping interconnectedness. This is a really important measure. I had asked why this wasn’t made a top priority as soon as Bear was rescued, because the reason for preventing a collapse was no one had the foggiest idea of how bad the collateral damage would be (pun intended). I suppose four years late is better than never.
Back to the speech (emphasis ours):
Work is also underway to evaluate what changes would be required to make the future bankruptcy of large complex firms less disruptive, while also developing an alternative means for the orderly resolution of such firms outside the normal bankruptcy process.
The costs to society of large complex financial firms failing can be reduced at least to some degree by having firms, working in conjunction with their regulators, “pre-plan” their own failure through the so-called “living will” process. The largest and most systemically important banks submitted their “living wills” to the Federal Reserve and the FDIC this summer. We have reviewed the first iterations of their plans and are currently drafting feedback for the firms to incorporate in their next submissions. Through such “living wills,” regulators are gaining a better understanding of the impediments to an orderly bankruptcy. This is the necessary first phase in the process of determining how to ameliorate these impediments over time and then doing so.
In my view, this initial exercise has confirmed that we are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society. Significant changes in structure and organization will ultimately be required for this to be achieved. However, the “living will” exercise is an iterative process, and we have only taken the first step in a long journey.
The second way to potentially minimize the negative externalities from a firm’s failure would be to avoid a bankruptcy proceeding altogether and instead resolve the firm under the Dodd-Frank Act’s Title II orderly liquidation 7 authority.8
The “single point of entry” model has much promise, but much remains to be done before it could be implemented with confidence for a globally active firm. Title II authority is U.S. law. Subsidiaries and affiliates chartered in other countries could be wound down under the bankruptcy laws of those countries, if authorities there did not have full confidence that local interests would be protected. Certain Title II measures including the one-day stay provision with respect to OTC derivatives and other qualified financial contracts may not apply through the force of law outside the United States, making orderly resolution difficult.
The fact that the US firms can’t be put into bankruptcy gracefully (and that the living will process is at this point an exercise for regulators to look at the legal plumbing) isn’t exactly surprising. And it should come as no surprise that Dodd Frank’s orderly resolution authority runs into serious shortcomings with firms with big foreign operations. Administration defenders pooh poohed our reservations which we stated over a year ago and tracked Dudley’s. Bankruptcy is always national, and foreign regulators could put foreign subs into bankruptcy (the odds of that are if anything higher than before; foreign creditors were treated shabbily by Judge Peck in the Lehman bankruptcy, so a foreign regulator might want to get out in front of US regulators if at all possible. And this wasn’t just our view. From a May 2011 post:
For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it “recognizes the strong likelihood of ring fencing in a crisis” due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that “helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.” In other words, it accepts a national process as inevitable and recommends dealing with that reality.
But not to worry. Spencer Bachus pointed out in a paper his office published last month, that despite the claims of Dodd Frank fans that it barred bailouts, he showed how there is still plenty of room for rescues:
Among other things, the “resolution authority” gives the FDIC the power to lend to a fail- ing firm; purchase its assets; guarantee its obligations; and — most important — pay off its credi- tors. The “resolution authority” also gives the FDIC the authority to borrow money from the Treasury. Lots of it. How much? The FDIC can borrow up to 10% of the book value of the failed firm’s total consolidated assets in the 30 days immediately following its appointment as receiver. After those 30 days, the FDIC can borrow up to 90% of the fair value of the failed firm’s total consolidated assets.
So while at least stockholders would get wiped out, we seem to have institutionalized the Geithner put: “no bank bondholder will take any losses.” Dudley account of all the things that need to happen to solve the TBTF problem in the close of his speech make clear we aren’t close domestically and even less close on the international front. So expect more stealth and probably overt big bank salvage operations in your future.
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Yves,
The solution to financial contagion (the interconnectedness problem) has always been to force the big banks to disclose their current exposure details.
This information lets all of a bank’s counterparties adjust their exposure to an amount they can afford to lose given the risk of the bank.
Reducing exposure will happen as investors will put pressure on the banks to reduce their risk (market discipline).
Regulators will never be able to effectively reduce interconnectedness. They need market discipline to do this for them.
“The solution to financial contagion (the interconnectedness problem) has always been to force the big banks to disclose their current exposure details.”
@Richard,
The best course is to make sure they are broken up. As simpel as that. But do you expect anything meaningful (for American Citizens) to happen with Obama, Geithner, bernanke. As far as this trio is concerned only banksters count and no one else. So actions and rules will follow this goal
Too big to fail is too big to exist. This should also mean more firms, not less and a more compeative market….
Never never never gonna happen.
A firm’s trading positions is its most valuable competitive information. Hedge funds go to great lengths to divide their business among prime brokers so no one knows their positions. When traders figure out someone has a large or largish position that they can’t get out of quickly (LTCM and London Whale were extreme versions) they take advantage and sell into those positions, deliberately putting them in distress. The banks will say, correctly, that they have good reason for keeping this information to themselves.
Yves,
I happen to agree with your observation that making the banks disclose their positions is never going to happen (particularly while Tim Geithner is there to protect the banks).
If banks were required to disclose their positions, it would immediately achieve the aims of the Volcker Rule and the banks would shed every proprietary trade.
As for breaking up the TBTF, disclosure does this by letting market discipline force the banks to beak themselves up.
Banks with 100s of subsidiaries for regulatory arbitrage will face higher costs than those who are simply in the lending business. Higher costs that more than wipeout the profits from these subsidiaries.
The fact that banks will fight this disclosure and do everything in their considerable power to make sure it doesn’t happen is no reason not to keep it on the menu of options for fixing the system.
I read Dudley’s speech with interest because it does at least publicly recognise the most obvious shortcomings in the current rescue and resolution frameworks.
But the regulators are still (and the tone of the speech gives this away) in complete denial of the mendaciousness of the organizations they are dealing with here. They are still in the duplicity game and actively deceiving the authorities who are — again, still — implicitly trusting their problem children’s words despite they fact that they’re proven congenital liars.
One TBTF I am aquatinted with had to provide a daily cash liquidity position (presumably so the regulator concerned knows how much cash or very similar equivalent it needs tonnage access to itself). Because of poor internal systems this information was not readily collateable. Rather than ‘fess up, we’re producing a wholly misleading output. The regulator accepts this at face value. No audit or basic “follow the money” analysis was undertaken.
Such naieve trust would be charming… If it wasn’t so dangerously misplaced.
“tonnage” = “to arrange” — ability to edit one’s comments is #1 on my NC enhancements wish list :-)
Ahhh…
Free markets….
If only they were allowed to work…
You want the Fed controlling rates and liquidity?
You want the Government bailing out banks and other institutions?
You want the Government to spend the private sectors purchasing power?
Than be ready for non transparent markets.. and in-balances.
As Richard said above, only the market can do this… But us humans just think we are too smart and can take certain actions without any reaction…
When will we realize that free markets are the answer?
That very much obviously depends on your definition of “free markets”, and if it includes no regulation, as most free marketers like to define it, then we would have an even worse situation.
The religion of “free markets” is a false one. There is no such thing.
Of course there is.
The market, be it housing, equities, food, education, etc can self regulate. What is regulation needed for?
Free markets can exist if we remove the useless regulations.
Don’t feed it, JCC. It will only feel encouraged. Then it will approach you, demanding more handouts, and possibly brush against and … ew, slimy!
The solution is to break up large complex financial institutions in to small simple financial institutions that can no longer be TBTF. Of course that would require a leader such as Teddy Roosevelt with the guts and muscle to take on the TBTF crowd as Teddy took on the Trusts….and break them apart.
Don’t expect any prosecutions either
REPORT: OBAMA ASKS HOLDER TO STAY FOR SECOND TERM
He’s back. President Barack Obama reportedly asked Eric Holder to stay as attorney general after he’s inaugurated for a second term, and the controversial Cabinet head agreed.
more http://www.breitbart.com/Big-Government/2012/11/13/Holder-Is-Staying-As-Attorney-General
Report: Cronyism, political donations likely behind Obama, Holder failure to charge any bankers after 2008 financial meltdown
http://dailycaller.com/2012/08/07/report-cronyism-political-donations-likely-behind-obama-holder-failure-to-charge-any-bankers-after-2008-financial-meltdown/?print=1
Banker Math Meets the Justice Department’s CROOKS
http://www.bloomberg.com/news/2012-11-15/banker-math-meets-the-justice-department-s-cooks.html
It is quite simple: The insolvent TBTF (JPM,Citi et al)have been, and will continue to be bailed out as a matter of National Security.
If their exposures and counter-party risks were to be made explicit, the Dow would drop 90% overnight. Instead, the process will take a few years.
Has this site discussed the secret 4 Trillion+ in bank welfare that dwarfed TARP and included almost 1 trillion on one day alone in 2008?
I hereby pledge 5% of all profits from 2014 Put positions to Naked Capitalism. Yves response to the CBO’s invitation was remarkable. I am sure thay would have hinted at all sorts of “future access” in exchange for easing up, “just a bit”.
Make that 2013-2014 Put positions.
Free market will self correct is half-witted nonsense. Proof of the statement is easy to comprehend and demonstrate. Even a dog understands.
A dog as a puppy is taught – even has innate hard wiring that informs it not to take a crap in the den where it lives. If the free market has ‘creative destruction’ then it must have ‘destructive destruction’. You don’t let a large carnivore freely roam in a children’s cafeteria that only serves vegetables. A free market, left to itself, does not care about good and bad and, it will self correct to either one if left free.
Nature will self correct without a single care about any flora or fauna in it’s way, just as a free market will self correct without a single concern about the humans who created it. So let us not pretend that good results and bad results are something that we can not do anything about. It is not hard to tweak the free-market into a place where it benefits our future and raises all boats, not hard at all to do. The only problem is that people who can make a difference believe (whether it is for self interest or good or bad or indifferent or lazy or whatever) some easily discredited malarkey and, are too overwhelmed (self interested, survival only, good, bad, lazy, overworked etc.) to devote time to see the trees through the forrest.
Geithner put: “no bank bondholder will take any losses.” Then why would a bond be issued in the first place?
Dudley occasionally states the obvious, but of course there is also what he doesn’t say. If most commercial banking was turned into a plain vanilla utility, that would eliminate a lot of risk, and size would be largely unimportant. As part of the plain vanilla, I would ban commercial banking from dealing with money markets. I would do the same between pensions and hedge funds. The idea here is to eliminate exposure to the shadow banking system and reduce its size.
I would also outlaw CDS, HFT, and dark pools, and either outlaw or put strict limits on other swaps, derivatives, and OTC trading.
Dudley is like someone concerned about inadequate means of dealing with the murder and mayhem of pirates without ever seriously entertaining the notion of outlawing piracy and going after the pirates.