‘Citi Weekend’ Shows Too-Big-to-Fail Endures: Simon Johnson

Democrats like to say that the Dodd-Frank financial overhaul legislation ended the problem of too big to fail because large failing financial institutions can now be wound down in an orderly manner.

Republicans, including those now running the House Financial Services Committee, dispute that the Dodd-Frank resolution framework is workable and insist that if big banks get into trouble on their watch that they will be allowed to go bankrupt.

Last week’s report by Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, suggests that the views of both sides are likely at odds with future financial realities.

The report, titled “Extraordinary Financial Assistance Provided to Citigroup Inc.,” focuses on the “Citi weekend” in November 2008 when the bank received additional financial assistance from the government -- just weeks after the U.S. had injected capital into all the big banks in the first wave of TARP bailouts. The report reveals fresh details about who made the key decisions and on what basis.

The most interesting quotes are from Tim Geithner, who was both president of the Federal Reserve Bank of New York and President Barack Obama’s pick as Treasury Secretary (his nomination, announced that Monday, was leaked to the market the previous Friday.)

Geithner is refreshingly frank that too big to fail hasn’t necessarily been ended.

‘Just Don’t Know’

“In the future we may have to do exceptional things again if we face a shock that large,” he said, according to the report. “You just don’t know what’s systemic and what’s not until you know the nature of the shock.”

Dodd-Frank supposedly gives any administration better tools but if you look closely at the details -- highlighted in the Treasury letter attached to the report -- you see most of the emphasis is on the resolution authority that allows the government to close financial institutions.

But this doesn’t apply to our largest global banks; there is nothing in the Dodd-Frank authority that applies to the overseas operations of a Citigroup, JPMorgan Chase or Goldman Sachs. So if a big global bank were to fail, it would set off a scramble for assets today just like it did when Lehman Brothers collapsed in September 2008 -- or would have if Citigroup had gone under the following November.

‘Gut Instinct’

This is also a major problem for the “just let ‘em go bankrupt” philosophy. There is no framework for cross-border bankruptcy, in the sense of clear rules about who gets compensated with what kind of assets. The courts can presumably sort it out, but it would take many years and cost billions of dollars in legal and other fees. As a result, if a large bank is on the brink of failing, everyone will assume the worst around the world and run for the doors.

Barofsky’s report points out that government decision making on the Citigroup bailout was ad hoc and largely motivated by “gut instinct” about what the consequences might be. Then-Treasury Secretary Henry Paulson was characteristically blunt at the time: “If Citi isn’t systemic, I don’t know what is.”

Sheila Bair, head of the Federal Deposit Insurance Corp., and other FDIC officials deferred to the judgment of Geithner and his team.

In a crisis there are no objective criteria, thus no way to know the full consequences; just a great deal of fear about what the failure of a large financial institution would do.

Like Physics

Size isn’t paramount, but it does matter a lot. If someone tells you that Earth is about to be hit by a meteor, and also tells you its density, impact velocity and impact angle, you then should have one question: How big is it? (You can plug in the parameters online to see for yourself.)

In this scenario, bigger isn’t better; it’s worse. It’s the same with banks -- as seen during the Citigroup weekend. The bank was huge. It was very highly leveraged. It was profoundly global. There was no legal authority that could handle orderly resolution. All of this is still true today, as the report makes clear.

Or perhaps the situation is worse.

“The government’s actions with respect to Citigroup undoubtedly contributed to the increased moral hazard that has been a direct byproduct of TARP,” Barofsky wrote.

As of last January, a senior New York Fed official still viewed Citigroup as too big to fail, and told the special inspector general that if history repeats itself, there is “no question we would do it again (with) a similar or different program,” according to the report.

Next Time

Or we could also make the biggest banks smaller -- ideally, small enough to fail. This was the proposal of the Brown-Kaufman amendment to Dodd-Frank, which died on the Senate floor, largely because of opposition from Geithner and the Treasury Department. So we’ll do nothing, it seems, except let these massive banks become bigger and even less well managed.

Until next time, the people who run the country will again face the same choice as in November 2008: provide an unsavory bailout for management, shareholders and creditors that rewards failure and stupidity, or run the risk of causing a second Great Depression.

If the big banks get large enough, we’ll become like Ireland today -- saving those institutions will ruin us fiscally, destroy the dollar as a haven currency, and end financial life as we know it.

(Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,” is a professor at MIT’s Sloan School of Management and a Bloomberg News columnist The opinions expressed are his own.)

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