Filed Under:Your Practice, Regulatory

Too-big-to-fail problem still haunting us

Opinion

(AP Photo/Katsumi Kasahara)
(AP Photo/Katsumi Kasahara)
(Bloomberg) -- The Federal Open Market Committee transcripts from 2008, released Friday, are a stark reminder of the damage done by the financial crisis and the terrible choices policy makers face when large, complex financial institutions fail.

In one critical meeting on Sept. 16 (the day after Lehman Brothers Holdings Inc.'s bankruptcy), Tom Hoenig, then the president of the Federal Reserve Bank of Kansas City, stated the problem succinctly: “I think we tend to react ad hoc during the crisis, and we have no choice at this point. But as you look at the situation, we ought, instead of having a decade of denying too big to fail, to acknowledge it and have a receivership and intervention program." Hoenig then warned: "We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so."

See also: Bernanke says Fed increasing financial monitoring

Chairman Ben S. Bernanke agreedand noted, "We need a strong, well-defined, ex ante, clear regime. But we have the problem now that we don’t have such a regime, and we’re dealing on a daily basis with these very severe consequences. So it is a difficult problem."

The 2010 Dodd-Frank Act created such a regime. Regulators, to their credit, have responded by implementing the law’s prohibition against using taxpayer funds to keep open failed institutions and by creating a transparent, clearly defined process to manage the failures of large, systemic financial companies.

Yet, even with meaningful progress, real doubts remain about the end of too big to fail. One reason is that regulators still have many substantive reforms left to deliver before the next failure. But another reason is that the public and the markets simply don't believe the government can or will let such large companies fail when the time comes.

See also: Give us tougher financial reform, Americans say

On the substance, real risks remain. Although Dodd-Frank created a new orderly liquidation authority for potentially systemic institutions, that authority should be just a backstop. The real policy goal must be ensuring that these institutions can fail like all others -- in a standard bankruptcy process, without the need for government support.

Dodd-Frank makes this clear in Section 165 where it requires regular “living will” filings designed to show that a financial company can credibly fail, without systemic disruptions, in bankruptcy. If a company can't credibly make that showing, the law allows regulators to limit its activities or break it up.

There is no evidence that these large institutions have made credible progress toward restructuring themselves so they can fail like everyone else. They are still huge, complex, interconnected and entangled in cross-border derivatives. Their failure in bankruptcy would probably disrupt many of the essential services markets need to operate.

Similarly, while the orderly liquidation backstop is needed to protect against 2008-style bailouts, important parts of that process remain incomplete. These gaps provide opportunities for counterparties and bondholders to game the system at home, and leave legal uncertainties abroad.

Given all this, we shouldn't be surprised that markets continue to doubt that these institutions' investors and counterparties will be fully accountable for their losses. To make matters worse, market doubts can lead to funding advantages that encourage the biggest financial companies to get even bigger -- and the industry even more concentrated. In this way, too big to fail can become self-fulfilling.

One way to move forward is to accept the reality: Enact the strong rules needed to eliminate gaming of orderly liquidation authority and bankruptcy, and let the market see things for itself.

This means requiring strong, simple leverage restrictions and meaningful loss absorbency at the holding-company level. It means getting institutions to simplify their structures so they are truly resolvable without bailouts, market breakdowns or assessments on the rest of the industry.

It also means regulators must improve transparency so that the public and markets can decide for themselves if the changes dispel their too-big-to-fail doubts. Existing living wills and Securities and Exchange Commission public disclosures are not giving investors and counterparties the information they need to assess whether these companies are becoming less systemic, less interconnected and more resolvable.

Better market understanding of how regulators will resolve these large, complex institutions should have a stabilizing influence the next time one of them gets into trouble.

Good progress has been made, but last week we had another stark reminder of the risks. When it comes to too big to fail, actions speak louder than words.

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