The Financial Stability Board released plans to make banks less “too big to fail”[i] Monday,[ii] continuing their long-running effort to prevent governments from ever profiting off failing banks again.[iii] Or taking losses. Or just bailing them out in general. Starting in 2019 or so, a few dozen of the world’s biggest banks must hold at least twice as much “loss absorbing capital” as normal banks so they can replace bailouts with “bail-ins,” Cyprus-style. Regulators, led by BoE chief Mark Carney, believe this will allow the system to deal with failing banks in an orderly way, without triggering panic, and without governments stepping in. We are skeptical.
Here is a quick outline of the FSB’s plan:
Who: “Globally Systemically Important Banks,” aka G-SIB—the 30 biggest and/or most interconnected banks globally.[iv] Here is the 2014 list.[v] Here is the geographical breakdown:
Exhibit 1: Where Big Banks Live
Source: Financial Stability Board, as of 11/10/2014.
What: Must hold “total loss absorbing capital” (TLAC) worth somewhere between 16% and 25% of risk-weighted assets. This amount must also be greater than or equal to 6% of total assets, sans risk-weighting. (This is also known as a “6% Leverage Ratio.”) TLAC means outstanding equity or bonds that can be converted to stock—also known as “contingent convertible bonds,” or “co-co.”[vi] TLAC does NOT include insured deposits or anything else listed in box 12 on page 16 of this.
Where: On their balance sheets.[vii]
When: No sooner than 2019, but the exact date is TBD. And the 20 participating countries will set their own phase-in schedules.[viii]
Why: Because 2008.
Or rather, because regulators appear to believe this was the chain of events in 2008:
1) Banks took too much risk and loaded up on securitized pools of toxic debt.
2) Banks were undercapitalized.
3) Banks couldn’t pay the piper when all that toxic debt went bad.
4) Banks had to get massive “taxpayer” bailouts.
5) “Taxpayers” lost huge amounts of money.
6) Banks, shareholders and creditors got off scot-free.
Now, this description is oversimplified and a bit skewed. We have been reading and collecting evidence on this topic since the downturn started in 2007. Here is the actual saga, near as we can tell:
1) Regulators relaxed the Net Capital Rule in 2004, allowing broker-dealers to increase their leverage so they could compete with European firms.
2) Meanwhile, banks made a lot of loans, then securitized and sold them to each other, hedge funds, broker-dealers and other investors. This spread default risk throughout the system and was generally recognized as good. As we write, some central banks want more of this.
3) An accounting rule called FAS 157, which forced banks to mark all assets on their balance sheets to the current market value (aka most recent sale price)—even if the assets were illiquid and the banks planned never to sell—took effect in November 2007.
4) Some mortgage-backed securities lost value.
5) Some broker-dealers and hedge funds had to sell these assets cheap to meet collateral requirements.
6) Every bank who owned those or comparable assets had to write down their value to that fire-sale price.
7) Repeat steps 4 – 6 a few times.
8) Bear Stearns ran out of cash and couldn’t get funding to cover operating costs, maturing short-term debt and other obligations.
9) But its assets exceeded its liabilities, so the Fed decided it was technically illiquid, not insolvent, and arranged for JPMorganChase to buy it out. (This included providing funding and relieving JPMorgan Chase of many of those toxic assets.)
10) Markets were happy for a while.
11) Repeat step 7.
12) Freddie Mac and Fannie Mae were nationalized.
13) Repeat step 7.
14) Lehman Brothers ran out of cash and couldn’t get funding to cover operating costs, maturing short-term debt and other obligations.
15) Even though its assets exceeded its liabilities, the Fed decided it was insolvent, not illiquid, and did not arrange and provide funding for another, stronger firm to buy it out. (According to transcripts, this included deliberately denying Barclays’ request for funding to buy Lehman.)
16) Shareholders and creditors took massive losses.
17) AIG got a bailout.
18) All hell broke loose.
19) The US government, um, strongly encouraged banks to take TARP money whether or not they wanted it.
20) Ben Bernanke said the Fed would adjust its guidance on FAS 157 on March 10, 2009.
21) Banks ultimately received $245.1 billion through TARP.[ix]
22) Banks ultimately repaid $274.7 billion.
23) The Treasury also profited off AIG, Fannie Mae and Freddie Mac.
24) But they didn’t send taxpayers a check for their share of this profit.
25) Many bank shareholders remain in the red.
26) The Fed made a profit of $10.3 billion on its toxic debt portfolios, Maiden Lane I, II and III.
27) But they didn’t send taxpayers a check for their share of this profit.
Now that is all very long, so here are three takeaways:
1) The catalyst here was an accounting rule that made $300 billion in loan losses balloon into $1.8 trillion of (temporary) writedowns. The astronomical difference between these two numbers tells you the accounting rule unnecessarily magnified those losses. That rule doesn’t apply to banks’ “held-to-maturity” assets anymore. Mark-to-firesale is over.
2) The sheer panic in September 2008 happened because regulators played fast and loose with the definition of bankruptcy—namely the difference between “illiquid” and “insolvent”—and created confusion by arbitrarily bailing out some banks and allowing others to die.
3) The feds made a boodle on these bailouts. Taxpayers did not take a loss.
Now, we aren’t suggesting bailouts are wonderful and good. A more market-oriented solution is theoretically and philosophically sound. We just think regulators are being a little Pollyanna if they think their plan will prevent bank runs, bailouts and overall chaos whenever the next panic strikes. We also think, based on the final numbers (and background circumstances) from 2008, that it is perhaps a solution in search of a problem. This makes us question whether the exercise is worth what banks warn is a high cost.
Why? Four reasons.
1) They haven’t addressed whether and how central banks will serve as lender of last resort. The Fed was created in 1913 to provide liquidity to otherwise solvent banks who need cash in a pinch—usually in a crisis when other banks are hoarding cash. Markets might not function well if shareholders and creditors don’t have clarity on this. Not knowing makes investors and depositors feel insecure and could accelerate a bank run.
2) In parallel, they haven’t addressed whether illiquid and insolvent are the same. Some NY Fed people believe the Fed erred in 2008 by declaring Lehman insolvent when it really just needed some emergency cash. A lack of clarity on this could accelerate a bank run, too. Moreover, inconsistency during the next crisis could cause a panic—what happens if one illiquid but otherwise probably solvent bank gets to tap the Fed, but another illiquid but otherwise probably solvent bank is forced to wipe out investors and fold?
3) The FSB people seem to assume big buffers will make the whole market less prone to panic. We have a lot of faith in the irrational human race to panic regardless of how much cash banks have. History has witnessed it over and over again since the dawn of banking and markets.
4) The government can always just step in anyway if they think it’s necessary for the good of mankind. Which could lead to the same picking winners and losers confusion as in 2008.
Hey, we get it, they want to make the banking system safer. But there is a tradeoff between “safety” and bank lending. Any truly safe bank would never lend a cent ever. There is a happy medium, we question whether this is it.
In the US and UK, these rules probably don’t create much of a headwind, given regulators here and there have long planned something similar to Carney’s announcement. But for the rest, this is a headache. Some have to raise a lot of money. Some might have to restructure so they can issue co-cos without jacking their funding costs through the roof. Some would like to restructure but need their governments to change some rules before they’re legally able to. None of this bodes well for banks to goose lending any time soon. The added compliance costs could also weigh on earnings, and if banks must issue new equity to meet the requirements, shareholders could be diluted.
We realize this is an overly simplified cost-benefit analysis, but we just don’t see how this stacks up as a major positive.
The headwinds it introduces probably aren’t big enough to derail the expansion, and again, US banks are largely in the clear here. We are also perhaps many, many years away from testing this plan for real. So just consider this our effort to prevent complacency from building up. Whenever the next crisis hits, we wouldn’t expect resolution to be an orderly piece of cake.
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[i] We are skeptical that “too big to fail” is either a thing or hugely dangerous for the financial system. That is a topic for another day.
[ii] Plans do not include making banks smaller. Maybe less “faily,” but maybe not.
[iii] We refuse to call this a “taxpayer profit,” because the IRS never sent us a check for our share of the TARP profits. Or gave us a “TARP profit tax holiday.” Strangely, we didn’t hear one single candidate campaign on this platform in midterms.
[v] Emerging Markets banks do not need to comply at present.
[vii] Maybe also a vault or e-vault or something.
[viii] Technically this is a G-20 initiative. But only 11 are immediately impacted, and the eurozone will adopt it centrally. So we guess “20-ish nations” is more correct.
[ix] This doesn’t include AIG, credit institutions, Fannie or Freddie. Or the auto companies.