Fed Conference in Hotlanta – Turning up the Heat on Too Big to Fail

Last week I had the opportunity to attend the Atlanta Federal Reserve‘s Financial Markets Conference, titled Maintaining Financial Stability: Holding a Tiger by the Tail. This year’s topic – as the pun in the title suggests – was the regulation of financial firms to manage tail-risk events. Tail-risk events are those that have a statistically low probability of happening, but a large potential cost if they do. They’re called tail-risk events because in a standard normal distribution curve that has a peak in the middle and sloping tails out to both sides, these are the events that take place out in those tails.

Tail-risk events associated with the financial system negatively affect a country’s financial system, and a stable, developed financial system is a key condition for economic growth. Banks and other financial intermediaries exist to move money from households and businesses that have extra (savers) to those who need more (borrowers).  An efficient financial system reduces transaction costs and information costs (such as moral hazard and adverse selection), making it cheaper for firms and households to access credit.

The Pitfalls of Risk Management

One theme of the conference was a focus on a particular source of potential tail-risk: “too big to fail” institutions. The discussion was on progress in regulators’ ability to unwind these large interconnected financial institutions (a.k.a. systemically important financial institutions, or SIFIs) if one or more of them fail. The good news is that progress has been made. Under the Dodd-Frank Act, SIFIs now have to have “living wills,” plans showing how they may be unwound under bankruptcy code.  Had such things existed when Lehman Brothers failed, regulators’ jobs to unwind the firm certainly would have been much easier.

Speaking of which, Lehman isn’t actually dead, and won’t die until after 2017. Lehman will ultimately pay back about 18%, on average, of what it owed creditors (though, reports just out suggest that creditors of Lehman’s European arm may get all of their money back). According to the FDIC, with the new powers they have under Dodd-Frank Title II, they could have given Lehman’s creditors back an average of 97% of the money owed.  If a SIFI could legally and efficiently be unwound, that could eliminate the need for bail outs.  A clear path to bankruptcy would help reduce the risk of moral hazard; it would reduce the incentive for SIFIs to take on too much risk because they would no long think they’d ultimately be bailed out by the government.

Economist John Taylor and lawyer Ken Scott proposed the creation of a special judicial bankruptcy code for financial institutions – Chapter 14.  This proposed code could supplement and improve up the Title II powers endowed to the FDIC by reducing bureaucratic discretion and improving clarity in policy. But the real question is how do you get judges and creditors to agree on who gets their money back and who doesn’t?

In addition, regardless of whether you use judicial bankruptcy or the Title II powers bestowed to FDIC, it’s a reach, at best, to reasonably assume that global regulators would want to work within the boundaries of U.S. law to unwind a global company. For example, Lehman had about 2,000 companies globally. As the New York Times put it (quoting the FDIC’s own Lehman report), the only way that the FDIC could hope to deal with the global nature of a SIFI such as Lehman is, “The FDIC would have contacted the relevant foreign and domestic regulatory authorities and governments to coordinate the resolution.” Sounds simple, but contact the relevant authorities for 2,000 global companies? Really?

The ideal solution to the challenge of resolving a global financial institution would perhaps be the harmonization of bankruptcy laws as John Taylor and his colleague Ken Scott suggested.  However, that is a long way in the future, and at this point may be more applicable to sci-fi than SIFI.

You can check out more of my thoughts on the Atlanta Fed conference in our Weekly Economic Insights, as well as views on China’s economy and Europe’s struggling recovery.

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