Too Big to Fail Not Fixed, Despite Dodd-Frank: Simon Johnson

Oct. 10 (Bloomberg) -- Here we go again. Major shocks potentially threaten the solvency of some of the world’s largest financial institutions. Concerns grow over the ability of European leaders to shore up their banks, which are reeling from a sovereign-debt crisis. In the U.S., the shares of some large banks are trading at less than book value, while creditor confidence crumbles.

Private conversations among economists, regulators and fund managers turn naturally to so-called resolution powers -- the expanded ability to take over and wind down private financial companies granted to federal regulators by the Dodd-Frank financial reform law. The proponents of these powers, including Tim Geithner and Henry Paulson, the current and former U.S. Treasury secretaries, argue that the absence of such authority in the fall of 2008 contributed to the financial panic. According to this line of thought, if only the Federal Deposit Insurance Corp. had the power to manage the orderly liquidation of big banks and nonbank financial companies, the government could have decided which creditors to protect and on what basis. This would have helped restore confidence, it is argued.

Instead, the government was forced to rely on the bankruptcy process, as in the case of Lehman Brothers Holdings Inc., or complete bailouts for all creditors, as in the case of American International Group. The FDIC already has limited resolution authority, which functioned well over many years for small and medium-sized banks.

Imposing Losses

If it determines that a bank has failed, the FDIC is able to protect retail depositors fully, while wiping out shareholders and imposing losses as appropriate on creditors. But can such powers really be extended to cover the largest banks? And how would this affect today’s unstable situation? The answers are no, and not very well, for three big reasons.

First, the resolution authority under Dodd-Frank is purely domestic -- there is no cross-border dimension. This presents a major problem if large financial institutions, which typically have extensive international operations, need to be shut down in an orderly way. U.S. legislation can’t specify how assets and liabilities in other countries will be treated; this requires an intergovernmental agreement of some kind.

But no international body -- not the Group of -20, the Group of Eight or anyone else -- shows any indication of taking this on, mostly because governments don’t wish to tie their own hands. In a severe crisis, the interests of the state are usually paramount. No meaningful cross-border resolution framework is even in the cards. (Disclosure: I’m on the FDIC’s Systemic Resolution Advisory Committee; I’m telling you what I tell them at every opportunity.)

Preemptive Use

Second, it has never been clear that any government agency would be willing to use such resolution powers preemptively -- before losses grow so large that they threaten to rock the macroeconomy.

The FDIC issued a fascinating paper early this year on how it would have handled Lehman differently if today’s resolution powers had existed in early 2008. If you’d like to think about how resolution works in practice, I highly recommend the paper (see my summary here). But a crucial assumption in it is that the Treasury Department under Paulson would have cooperated with the FDIC, or at least not stood in its way, as it sought to liquidate a troubled, though not yet collapsed, megabank.

I dealt with the Treasury in early 2008 while I was chief economist at the International Monetary Fund. Based on what I saw and heard then, it is hard to believe that Paulson’s team would have supported an early intervention in Lehman.

No Early Action

And given everything we have seen over the past three years, it is similarly difficult to believe that Geithner, who was New York Fed president in 2008, would now support early action in the case of any major U.S. bank holding company.

Third, who would lose money in any potential liquidation? The fundamental premise of the resolution authority is that some creditors could face losses, but they would be imposed in an orderly and predictable manner to avoid undermining confidence and destabilizing the financial system. Any such thinking today seems far-fetched.

To impose losses on creditors who have lent to big U.S. banks would be to create fears similar to those post-Lehman. The presumption in financial markets is that the largest financial institutions are too big to fail. Events and policy actions since the fall of 2008 have reinforced this notion, with Treasury siding with the big banks over how to interpret the Volcker Rule, how much to increase capital levels, and how to proceed at almost every stage of the reform process. Politicians and officials offer plenty of rhetoric to the contrary, but it’s just rhetoric.

Break Up Banks

To make the FDIC resolution powers credible, large banks should have been made small enough and simple enough to fail.

Of course, if we had really done that, we wouldn’t need a resolution authority. When CIT Group failed in the fall of 2009, it had a balance sheet of about $80 billion. There was no bailout, the firm’s debts were restructured, and today it is back in business -- with an appropriately slimmer $48 billion in total assets at the end of the 2011 second quarter.

There were no adverse systemic consequences for the financial system. I’ve talked to many analysts and people active in financial markets, and cannot find any measurable consequences from the CIT failure on the real economy, including on access to credit for their customers, which were small and medium-sized businesses.

Cross-Border Banks

This was a success for the market system: Financial failure led to creditor losses and restructuring, rather than systemic panic. Unfortunately, the resolution powers won’t work for the largest cross-border banks. And bankruptcy for financial institutions would seriously undermine confidence, as happened with Lehman.

The financial system hasn’t become safer since September 2008. We are not in a strong position to weather the financial storms that now appear on the horizon.

(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)

To contact the author of this column: Simon Johnson at

To contact the editor responsible for this column: Paula Dwyer at

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