“Too big to fail” will get partial cure in 2011
— The author is a Reuters Breakingviews columnist. The opinions expressed are his own —
The “too big to fail” problem will be partly fixed in 2011. Global regulators should end up agreeing to make a select group of big global banks hold higher levels of capital. That will make them safer, while removing some of the benefit they get from being big. But eliminating the taxpayer guarantee enjoyed by large lenders will require more fundamental measures. That will take years to achieve.
Regulators everywhere agree that banks deemed too big to fail are dangerous. Because of their importance they enjoy implicit — and sometimes explicit — government support. As a result, large lenders tend to have higher credit ratings and pay less for deposits and wholesale funding. This encourages them to become even larger and more interconnected.
Broadly speaking, there are two ways to tackle this problem. One is to make big banks less likely to fail. The other is to reorganize them so that they can be allowed to fail without threatening the system. In 2011, regulators are likely to concentrate on the first option.
The Basel Committee on Banking Supervision, which sets global rules, is planning to make large and interconnected banks hold more capital. Most big bank executives believe they will be forced to hold an additional buffer equivalent to at least 3 percent of risk-weighted assets. This will take their minimum capital ratios north of 10 percent, compared to 7 percent for smaller lenders. The buffer may be in the form of so-called contingent convertible bonds, or CoCos: debt that converts into equity if the bank gets into trouble. However, small countries with large banks may demand even bigger buffers. Swiss regulators have already told UBS and Credit Suisse to lift their capital ratios to 19 percent.
Higher capital ratios will make big banks safer, while the cost of the extra equity will offset some of the benefits of cheap funding. But the approach has flaws. First, it’s not easy to spot systemic banks. Lehman Brothers, for instance, was not particularly large by U.S. standards. But it was so enmeshed in the financial system — and its failure so chaotic — that it triggered a global meltdown.
Second, by drawing up a list of systemic institutions, regulators risk sending a signal that these banks are totally safe — essentially making a commitment to bail them out. That would make the too-big-to-fail problem even worse. Finally, national regulators are bound to interpret the rules differently, creating an uneven playing field.
The alternative is to restructure banks so that they pose less of a risk. Here — setting aside the draconian idea of breaking them up into small pieces — there are two broad schools of thought. The first is to force lenders to organize themselves so that they can be wound down safely. This is why regulators have asked large banks to draw up so-called “living wills”, setting out what they will do if they get into trouble. This could involve selling a business to raise extra capital. But it could also involve ring-fencing important bits of the bank, like those that take deposits or process payments, while declaring less systemic parts insolvent.
This is what the Federal Deposit Insurance Corp already does with smaller U.S. lenders. But designing rules to tackle large cross-border banks is harder: it probably requires most of the world’s developed economies to introduce new rules, and that will take years.
Meanwhile, some regulators are pushing to introduce mechanisms that will allow them to recapitalize failing banks without winding them down or bailing them out. This approach — known as the “bail-in” option — involves converting a bank’s debt into equity when its capital ratios fall below a certain point. The advantage is that the bank remains intact, while creditors take a haircut and shareholders suffer what Thomas Huertas, of the UK’s Financial Services Authority, has dubbed “death by dilution”.
It’s too early to say whether living wills or bail-ins — or some combination of the two — will prevail. As long as the problem remains unsolved, politicians and regulators will remain under pressure to resort to more radical solutions, such as putting an explicit cap on bank size. Privately, regulators hope that the measures they do take will eventually prompt big lenders to voluntarily shrink or dissolve into their constituent parts.
What is clear is that just making big banks hold more capital will not solve the too-big-to-fail problem. But it is probably the best that regulators can hope to achieve in 2011.