'Too Big To Fail' Revisited

Nouriel Roubini, 11.05.09, 12:01 AM EST

Regulatory reforms of systemically important institutions.

Although the G-20 finance ministers pledged stronger prudential regulation and financial oversight of systemically important firms at their September meeting, there is no consensus yet among regulators, lawmakers and academics on how best to proceed. I noted recently that the problem of banks being too big to fail is even bigger now than it was before the crisis: "Why don't we go to a system where they're not too big to fail to begin with? The true solution to the too-big-to-fail problem requires more radical choices. In addition to an insolvency regime, such institutions should be broken up, and unsecured creditors of insolvent institutions should have their claim automatically converted into equity. A separation of commercial banking and risky investment banking should also be considered. Thus, some variant of the Glass-Steagall Act should be reintroduced."
If the government creates a new firewall between deposit-taking institutions and investment banks, as was the case before the repeal of the 1935 Glass-Steagall Act in 1999, only the former group would receive access to lender-of-last-resort facilities and deposit insurance. The latter should be subject to receivership should they get in trouble. Advocates of this solution include Paul Volcker (who chaired the Group of 30 report) and Mervyn King (Governor of the Bank of England); and even Alan Greenspan favors a breakup, according to recent statements (although he supported the repeal of Glass-Steagall). Among policymakers, King has made a particularly forceful case, noting that "it is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place."

Others argue that in the era of financial innovation, size by itself is not the main issue, but rather the degree of complexity and interconnectedness (e.g., Northern Rock ( NHRKF.PK - news - people ) in the U.K. and Bear Stearns in the U.S.) The solution, according to this view, entails stricter capital, liquidity, compensation and counterparty risk management requirements for designated institutions to set the proper incentives against excessive risk taking, including explicit insurance premiums against systemic risk. The Obama administration's proposal and the updated Turner Review in the U.K. are in this camp, as are many academic advisory groups (see e.g., NYU Stern report, CEPR/Geneva Report, as well as the de Larosiere report in the E.U.). Charles Goodhart, co-author of the CEPR/Geneva report, recently made the case against "narrow banking," citing the pro-cyclical boundary problem of deposit flows in and out of narrow banks as one issue, and the maintenance of credit flows as a second. Similarly, some point to the need to "reevaluate the priority treatment of qualifying repo and swap contracts to determine if it unnecessarily adds to systemic risk" (Squam Lake Working Group on Financial Regulation).
Meanwhile, as regulators and lawmakers on both sides of the Atlantic deliberate, the European Commission's Competition Commissioner Neelie Kroes has taken action in a move that effectively settles the debate from a practical perspective. On Oct. 27, 2009, she ordered the split of ING ( ING - news - people ), the Dutch "bancassurance" conglomerate that received bailout funds and was consequently determined to have been given an unfair advantage under State Aid rules. As expected, a few days later government aid recipients RBS and Lloyds of the U.K. reached an agreement with the government and the E.U. competition authorities calling for significant divestments of the banks' businesses over four years, as well as revised Asset Protection Scheme participation terms for RBS. (Lloyds will not participate in the APS but pay a compensation fee to the Treasury for the implicit protection received so far.) Meanwhile, the U.K. Treasury will inject 25.5 billion pounds of capital into RBS, for a total of 45.5 billion pounds--the costliest bailout of any bank worldwide, according to press reports.
In the U.S., on the other hand, the House Financial Services Committee presented a draft law on Oct. 27, 2009 based on the administration's June 17, 2009, proposal for comprehensive regulatory reform. The draft law conveys broad supervisory powers of designated systemically important institutions to the Federal Reserve Board. In addition to higher risk-based capital requirements, the new prudential standards for systemic institutions include leverage limits, liquidity rules, concentration limits and the drafting of a "living will" (i.e., a resolution plan). The Fed also receives authority to ask any systemically important firm to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities or to impose conditions on business activities.

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11/05/2009 11:45AM ET

Once the roles are assigned, the regulator has to decide on the exact quantity and composition of the new capital requirements. Since the adoption of a certain ratio is somewhat artificial and not very indicative as an early warning system--as the recent crisis has shown--economists are advocating market indicator-based contingent debt to equity swaps as an efficient restructuring tool for large institutions that wouldn't put taxpayer money at risk or trigger derivatives contracts. Nonetheless, Mervyn King cautions that while the inclusion of convertible debt in capital requirements is worth a try, this tool does nothing to address the moral hazard of designated "TBTF" institutions. On the contrary, "they still have an incentive to take really big risks because the government would provide some back-stop catastrophe insurance."
Ultimately, if the realized asset value shrinks below liabilities, an orderly resolution would be warranted. The House draft bill appoints the FDIC to the task. In the U.K., the FDIC served as a role model to the U.K.'s new Special Resolution Regime, instituted in the aftermath of Northern Rock. Many other European countries lack an equivalent mechanism, making the timely resolution of cross-border institutions a very difficult task, especially with respect to fiscal burden-sharing (as the example of Fortis ( FORSY.PK - news - people ) showed). Martin Cihak and Erlend Nier of the IMF review the legal framework in the E.U. and note that while the 2001 Directive on Reorganization and Winding-Up of Credit Institutions explicitly grants the home country that issued the banking license the sole power to initiate reorganization measures with full effect throughout the E.U., these principles do not apply to (wholly owned) subsidiaries that have their own licenses but whose operating systems are nonetheless fully integrated. Indeed, most cross-border expansion in the E.U. happened through subsidiaries. What is needed, then, is the institution of a special resolution regime at the holding level for cross-border banks on a fully consolidated basis, or at least some harmonization of rules at the state level.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics (RGE), is a weekly columnist for Forbes. (Read all of his columns here.) Elisa Parisi-Capone, senior analyst at RGE, assisted in the writing of this column.