Why Big Banks Are Insisting They Can Fail

The executives of the largest U.S. banks have lately been trying to make the case that they are as subject to market discipline as anyone else: If they get into trouble, they will be allowed to fail, no matter their size. Taxpayers won’t have to worry about bailing them out.

If only it were true.

Over the past few decades, the U.S. government has allowed the failure of only one large, systemically important financial institution, Lehman Brothers Holdings Inc. The fallout proved so disastrous that the Treasury soon found itself injecting capital into all of the country’s largest banks. The message was clear: If a bank is large and interconnected enough to threaten the economy, the government will have no choice but to rescue its creditors in the event of distress.

Regulators say times have changed. Their primary argument centers on a piece of the Dodd-Frank Act known as the orderly liquidation authority. The authority is supposed to give the Federal Deposit Insurance Corp. the tools it needs to wind down any financial institution with minimal collateral damage.

Picture a distressed bank holding company, with thousands of subsidiaries doing everything from processing payments to making loans to trading exotic derivatives. The authority allows the FDIC to swoop in and take control of the company, while ensuring that all the systemically important subsidiaries keep operating. To rebuild equity capital -- the company’s assets minus what it owes to creditors -- the FDIC can impose losses on creditors, converting them to equity holders in a “bail in.” Ideally, one or more smaller, better capitalized enterprises emerge.

Perpetuating Bailouts

Problem is, there’s no way to be sure the liquidation authority would work. Some prominent policy makers go so far as to say that it perpetuates taxpayer-funded bailouts, because it authorizes the FDIC to use government funds to keep distressed institutions afloat during the liquidation process. “This looks, sounds and tastes like a taxpayer bailout, just hidden behind different language,” Dallas Federal Reserve President Richard Fisher said in congressional testimony June 26.

One important question is how the FDIC could handle a serious crisis like that of 2008, when several large institutions got into trouble simultaneously. Panic could cause asset values to fall so precipitously that officials would be unable to ascertain the extent of losses, undermining confidence in the institutions they were trying to save. Foreign authorities might start seizing overseas assets of large U.S. banks to cover local creditors’ claims, complicating the FDIC’s work and fueling further panic. The only way to stop the rot could be for the government to step in and provide a blanket guarantee, as it has done consistently in the past.

Markets, for their part, aren’t showing much faith in the liquidation authority. Creditors are still lending to the large banks at artificially low interest rates, suggesting that they’re counting on getting bailed out in an emergency. Under international accounting standards, most of the six largest U.S. banks have so little equity that a mere 3.6 percent drop in asset values could be enough to render them insolvent. Nonetheless, as a recent Goldman Sachs study shows, they are able to borrow at roughly the same interest rates as smaller institutions that could survive much larger shocks.

One real danger is that the government’s resources could prove inadequate to save the financial system. The assets of the six largest U.S. banks, according to international accounting rules, stood at more than $15 trillion as of the end of 2012, roughly equal to the annual output of the U.S. economy. The burden of supporting such large institutions would weigh heavily on the U.S. government’s finances. If markets lost confidence in the issuer of the world’s reserve currency, it’s hard to imagine how they would function.

More Equity

Given the stakes and uncertainties, assuming that regulators can handle big bank failures isn’t good enough. It’s crucial to ensure that banks are less likely to fail in the first place. Economists have made a strong case that a requirement of one dollar in equity for each five dollars in assets -- enough to absorb a 20 percent loss -- would make the banking system a lot more resilient, and would benefit economic growth by reducing the probability of crises. Two U.S. senators, Louisiana Republican David Vitter and Ohio Democrat Sherrod Brown, are trying to address the issue by introducing a bill that would make U.S. equity requirements for the largest banks high enough to absorb a 15 percent loss.

Make no mistake: The orderly liquidation authority is a well-intentioned effort to protect taxpayers and the economy from financial institutions that have become too dangerous. We’ll be better off if we never have to test it.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.