The world economy faces a major problem: the largest banks in the US remain “too big to fail,” meaning that if one or more of them were in serious trouble, they would be saved by government action—because the consequences of inaction are just too horrifying. This problem is widely accepted, not just by state officials but by bankers too. In fact, there is near unanimity that fixing it is a top priority. Even Jamie Dimon, the powerful head of the very large JPMorgan Chase, says that “too big to fail” must end. Unfortunately, the Obama administration’s proposed approach—now taken up by the US congress—will not work. The centre of legislative attention is Senator Christopher Dodd’s financial reform bill, which has passed out of the senate banking committee and will presumably soon be debated on the senate floor. Dodd’s bill would create a “resolution authority,” meaning a government agency with the power to take over and close down failing financial institutions. The bill’s proponents argue that this approach builds on the success of the Federal Deposit Insurance Corporation (FDIC), which has a long record of closing down small and medium-sized banks in the US with minimal disruption and no losses for depositors. In this context, “resolution” means that a bank’s managers are fired, shareholders wiped out, and unsecured creditors can suffer losses. It is a form of bankruptcy, but with more administrative discretion (and presumably more protection for depositors) than would be possible in a court-supervised process. Applying this regime to large banks and to financial institutions that are not formally banks—and that do not have insured retail deposits—sounds fine on paper. But in practice there is an insurmountable difficulty with this approach. Think about the critical moment of decision: when a megabank, like JPMorgan Chase (with a balance sheet of roughly $2 trillion), may be on the brink of failure. You are a senior decision-maker—perhaps the secretary of the treasury or a key adviser to the president, for this is the level at which the plug must be pulled. You have Senator Dodd’s resolution authority and you enter the decisive meeting determined not to save the troubled bank—or, at worst, to save it with a substantial “haircut” (that is, losses) for unsecured creditors. Then someone reminds you that JPMorgan Chase is a complex global financial institution. The Dodd authority allows the US government to determine the terms of an official takeover only within its borders. In other countries where JPMorgan has subsidiaries, or other kinds of business, there would be “plain vanilla” bankruptcy—while some governments would jump in with various ad hoc arrangements. The consequences of these uncoordinated responses would be frightening, and bordering on chaos. This is what happened when Lehman Brothers failed in September 2008, and what happened two days later when AIG was taken over by the US government (in a resolution-type structure, with losses implied for creditors). The existence of a US resolution authority does not help contain the damage or limit the panic arising from a big global bank in trouble. The failure of such a bank could be managed in a more orderly fashion by using a cross-border resolution authority. But no such mechanism exists, and there is no chance one will be created in the near future. Responsible policymakers in other G20 countries are clear on this point: no one will agree ex ante to a specific way of handling the failure of any global bank. At the moment when JPMorgan Chase—or any of America’s six largest banks—fails, the choice will be just like that of September 2008: do you rescue the bank or let it fail, and face likely chaos in markets and a potential rerun of the depression? What will the president decide? He may have promised, even in public, that creditors would face losses, but on the edge of the precipice, which way will you, the beleaguered adviser, urge the president to go? Will you really argue that the president should leap over the edge, thereby plunging millions of people into a financial abyss? Or will you pull back and find some ingenious way to save the bank and protect its creditors using public money, the Federal Reserve, or some other emergency power? You will, in all likelihood, step back. When the chips are down, it is far less scary to save a megabank than to let it go. Of course the credit markets know this, so they lend more cheaply to JPMorgan Chase and other megabanks than to smaller banks that really can fail. This enables the bigger banks to get bigger. And the bigger they are, the safer creditors become—you see where this goes. Senator Dodd’s bill, as currently drafted, will not end “too big to fail.” As you can infer from the title of my new book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (co-authored with James Kwak), the global fallout will be dire.
