Should We Believe the Bank of England’s “No More Bailouts” Promise?

Michael Hudson sent an article No more bailouts: BoE chief says banks won’t be saved by taxpayers and wondered if we should take it at face value.

The short answer is “almost certainly not” but it also depends on what you mean by “saved by taxpayers”. There is a nasty tendency to exclude more than short-term liquidity provision by central banks, as not costing taxpayers because the rescue monies did not come out of the government’s Treasury. But Ed Kane has estimated that ZIRP represents an ongoing $300 billion a year subsidy in the US from the public to financial firms. As we have seen, laundering bank support through central bank liquidity support makes speculation look attractive relative to real economy investing, which hurts growth directly and indirectly, via increasing income and wealth inequality.

One reason to be skeptical is that any plan is a long way away from being concrete, and is subject to the usual bank consultation, as in watering-down process. The report duly notes that:

Under the new system, bank shareholders and lenders to banks such as bondholders would be the first in line to take the brunt of any future losses, if banks cannot pay creditors out of their own resources. Banks may also be expected to scrap dividends and rein in bonuses.

The new rules are a long way off being implemented, however. They will need to go through consultation and most new rules will only take effect by 2019. They would also require big global banks to hold a minimum amount of cash to make sure they don’t have to run to the government for emergency help.

From January 2019, big global banks like HSBC and Goldman Sachs would have to have an equity buffer of at least 16-20 percent of their risk-weighted assets.

The new buffer, known as total loss absorbing capacity or TLAC, must be at least twice the leverage ratio of a bank.

This is a separate measure of capital to total assets. Some of the buffer must also be held at major overseas subsidiaries to allay fears from regulators outside the country a bank is based in.

While this anti-bailout talk sounds well and good, there is a ton of devil in the details, and a second layer of problems.

Generally speaking, British and European regulators have been keen about the so-called “contingent capital” approach, in which equity holders, and a big chunk of the more junior debtors, have pre-agreed to have their economic interest reduced or wiped out if a bank gets in trouble.

Now this all sounds sensible and fair, right? These people signed up to stand first or close to first in line for eating risk in order to get higher returns. If you live by the sword, you should be prepared to die by the sword. So their wipeout or haircut, as the case may be, is supposed to amount to a pre-packaged bailout by investors rather than the general public.

The problem is American regulators have been less keen about this approach, and if they don’t fall in line with the Bank of England initiative, led by its governor Mark Carney, it won’t be a global standard. Note that another plank in the plan, which in theory has a lot of merit, is to end or limit what is now called the “home-host system”. In very crude terms, the regulator of the parent company is in charge of capital adequacy. Regulators of local subs defer to the parent regulator. At most, in bad times, they might ask the mother ship to send more capital to a local subsidiary. If that local sub is having an isolated problem, that might work out just fine, but those calls tend to come in when the entire bank is listing and the mother ship is not in a position to do much.

So having banks be more balkanized, in terms of having regulators demand that important local subs have some level of capital in them would be pro-stabilty. But big global capital markets banks will hate that, because they move the management of their trading books across time zones during the day, which is an operational process that does not map very well onto the idea of having activities, particularly capital and funding, sit tidily in nice local legal vehicles. Sure, you can make sure that retail banking and traditional commercial banking are properly funded in their local domiciles, but that isn’t where the big risks lie. Now perhaps there is some inspired solution, but at a remove, but as they say in Maine, this looks like “You can’t get there from here.”

But that isn’t the main reason US regulators have been cool on this contingent capital idea. The big reason is it will scare possible capital sources away when a bank looks wobbly. Recall that when banks started looking wobbly in 2007, many did a round of equity selling to dumb money, mainly Asian and Middle Eastern sovereign wealth funds. With a contingent capital structure required by regulation, coming in as a bottom fisher/rescuer is vastly more risky with an automatic cramdown mechanism in place and central bankers at least acting as if they won’t intervene if things go pear-shaped.

Now of course, defenders will argue that if the capital buffers are set high enough, there won’t be any need for extra topping-up capital if a bank gets in trouble.

But even the little experience we’ve had with contingent capital suggest it isn’t ready for prime time, and that banks and regulators may not have the will to invoke those terms when times are bad. We had lots of examples of that during the crisis. Recall, for instance, that Fannie and Freddie debt was absolutely not government guaranteed. That was clearly stated on the front page of every prospectus. But China and Japan held a lot of this debt on the premise that it was government-backed, and they made it plenty clear that they would not be happy if there was a default. Similarly, bank preferred stock was had been treated as equity capital in the US before the crisis. But banks had been encouraged to buy the preferred stock of other banks, by regulators no less, so putting a big bank into resolution and wiping out common and preferred shareholders would whack other banks’ capital levels.

IN 2013, Matt Levine discussed LLoyd’s Bank problems with theory versus practice for securities with regulatory contingencies. You can read his article for gory details, but in short form, Lloyd’s had issued a “enhanced capital notes” that counted as capital in 2009 but the bank could call if the rules changed and the ECNs no longer counted as capital. Well, the rules did change. Lloyds could have simply called the notes but instead wanted to do an exchange to give investors a bigger premium than they were entitled to. Even so, investors were still very very unhappy and complained to regulators.

And even more telling is that Levine, who is very clever and clearly did a lot of homework in writing the piece, got a note from an investor activist and told Levine he’d missed an important feature, which changed his analysis in a significant way. So if a derivatives expert and attorney like Levine has trouble puzzling this stuff out, image how much trouble mere mortals will have in understanding these instruments.

Regardless, a key point Levine makes still applies: even if you have clear contractual rights to make investors accept a reduction in their returns, that doesn’t mean you’ll find it to be in your best interest to enforce them when it comes time to pull the trigger:

There are some lessons here! One lesson is that there are exciting opportunities for winners and losers and taking advantage of, or being taken advantage of by, the frequent changes as regulators fine-tune post-crisis banking regulation. Lloyds could have — and Credit Suisse still could — saved a lot of interest payments with a free par call here due to changes in regulation. Instead it chose to take on the expense and pain of an exchange offer, making it I guess a bit of a loser, though there are other winners. BofA and Goldman are leading Lloyds’s exchange offer, and there will be other investment banking mandates to clean up other capital things that need fixing.

Another lesson is that you can’t always stand on your rights with providers of capital:10 If you’ll have a need for capital going forward, you have incentives to do what is perceived as fair by capital providers, even if technically you have the right to stick it to them.

Shorter: I wouldn’t rely on this great new untested type of scheme to be the salvation of the banking system. But the Bank of England and its European cohorts seem enamored o this shiny new toy, so I expect we’ll see a lot of experimentation and lurches.