An imperfect plan for fixing the next crisis

After the spectacular chaos of the last time that regulators and governments scrambled to rescue banks in the US and Europe, they have hammered out a plan for the next time. It is better than the absence of one in 2008 but who knows if it will work?

The authorities can run all kinds of stress tests on the capital structures of the world’s largest banks, trying to predict how well they would bear losses in a future crisis. The stress test they really need to run is on themselves – whether they will stick to their promise to work nicely with each other or will revert to self-interest.

In a truly serious crisis – the kind that only tends to come along every few decades – I suspect it would still be every bank regulator for itself. That is not to rubbish the efforts of the Financial Stability Board, which this week unveiled a plan to deal with troubled banks. It is merely to point out a reality that no amount of goodwill can erase.

Mark Carney, governor of the Bank of England and chairman of the Financial Stability Board that meets in Basel to plan such things, declared that the system had reached a “watershed” after years of regulators trying to fix the problem. Banks would have deeper reserves of capital, and officials would be better prepared.

But while central banks and regulators will have superior tools to rescue banks next time, they will have far less freedom of manoeuvre. In 2008, they could act first and face questions later. Next time, they will be under severe pressure – and in the US, a legal obligation – not to spend a penny of public money on the task.

If there is clearly enough private capital available – which the FSB’s plan is meant to ensure – everyone may behave nicely. But if there is even a tiny risk of it running out, every country will try to grab as much as it can. Any supervisor who let it be diverted to a foreign part of a troubled bank would be in trouble. It happened before when, for example, Lehman Brothers was carved up into parts and sold off separately. If it happens again, it could force the end of global banks, the complex, cross-border businesses that still dominate capital markets and lending despite being highly unpopular since the 2008 crisis.

Few tears might be shed. The failure of regulators to impose limits on the scope of 28 “global systemically important banks”, apart from the ringfencing of retail deposits in the UK, and the Volcker rule that restricts US banks from making some kinds of speculative investments, means they remain too large for comfort. The best we can hope for is that they are no longer too big to fail.

They are still behaving badly. The $4.3bn fines imposed yesterday on five banks including Royal Bank of Scotland and UBS for rigging foreign exchange markets, show how hard it is to improve their conduct. This activity took place not in the investment banking casino but in operations that are part of every large bank.


Yet dividing banks by nationality, to match the structure of central banks and regulators, would not solve this and it would hurt global finance and trade. That is why the FSB tried to get the US, Europe and Asia to agree on a common approach.

It managed it, despite inevitable compromises – the European exception, the Japanese exception and the Chinese exception (the last is that banks from emerging markets can ignore the most important part). As well as the higher, although still not high enough, equity ratios of Basel III, big banks must hold long-term bonds that can be forcibly “bailed-in”.

The heart of the deal is the “single point of entry” – the idea that a crisis-hit bank’s national regulator would secure enough capital to keep it going while writing down its assets and replacing its executives. The US would be confident enough in a German-led resolution of a global bank not to seize its Wall Street operation.

That would probably work if only one bank were in trouble and the rest of them were stable. Everyone would be on good behaviour and the bail-in bonds, positioned to reassure every regulator of the solidity of each of its divisions, would suffice.

In a broader crisis, however, everything would be under stress. In a public bailout, a strong sovereign can spend as much as it takes to prop the system up. No private bail-in can match that – even if a bank holds capital equivalent to 20 per cent of its risk-weighted assets, the resources available for its rescue are limited.

A mass bail-in of bank capital could also create distress in other parts of the financial system, among insurers and asset managers holding bonds that are swapped into equity. Randall Kroszner, a former Federal Reserve governor who is a professor at University of Chicago, points out that moving losses around does not make them disappear.

Regulators would be acting amid uncertainty, knowing they could not risk their own banks weakening to the point at which public money would be needed. It would require a great deal of discipline to stick with the FSB plan, and trust in a foreign regulator to ensure their banking systems survive the turmoil intact.

It is a step forward that banks will be better capitalised and regulators have a common plan. But it will be tested only in a crisis, when risk adversity will be at its height. It may not be enough.




John Gapper


Fonte: FT