Too-big-to-fail: three flaws in FSB approach | Simon Johnson

From Simon Johnson, professor at MIT Sloan and former chief economist at the IMF:

The world’s largest banks remain too big to fail, and this is likely to have dire consequences in the near future.

….Unfortunately, there are three flaws in the FSB’s [Financial Stability Board] framework that will prevent it from being effectively applied to large global banks.

First, by definition, global banks operate across borders, and there is no agreement among different national authorities regarding how to respond in a crisis. There is, arguably, better communication than there was before 2008, but when the chips are down, this will be worth little. The countries involved have different legal rules, different procedures for protecting local assets, and different court systems. A major international treaty could address all of this, but the immediate prospects for one are nonexistent.

Second, the FSB proposes to require a Total Loss Absorbing Capacity for all large banks. But TLAC is just jargon for saying that these banks should fund themselves with both equity and “bail-in-able debt” – debt that can be converted to equity (or wiped out) when there is an official resolution event. All this really means is that some debt can fall dramatically in value when government officials pull the trigger.

This may seem elegant in theory, but it is completely unworkable in practice. In any real crisis, the authorities’ real fear is that the fall in one asset price (the equity value of big banks) will cause other asset-price declines – leading to a broader contraction of credit. The idea of “loss-absorbing debt” is an oxymoron.

Third, what really matters for financial systems is the extent of equity financing – including how much equity banks are required to have. Current levels are so low – debt funds around 95% of total credit exposure in most big US banks (and a slightly higher share in big European banks) – that banks’ equity can be substantially wiped out by even moderate negative shocks.

The good news is that the Fed increasingly seems to be taking this point on board – and inching toward higher capital requirements for the biggest banks.

Source: Failure at the Financial Stability Board by Simon Johnson – Project Syndicate