Sanders, Clinton and the War Over Big Banks

Rejection of bankruptcy-safety plans proves a) that the system is broken, and b) that it's working.

This is war.

Photographer: John Taggart/Bloomberg

We found out Wednesday that five of the biggest U.S. banks couldn't explain how they could go bankrupt without taking down the financial system with them.

No wonder Bernie Sanders wants to break them up! They're just too damned big to fail.

Or, maybe … No wonder Hillary Clinton thinks that's crazy! Tough-minded regulators are putting the heat on bankers to write realistic "living wills," so why destroy a banking system that's being remade to work safely?

Bank living wills live at the intersection of arcane banking policy and raw politics. They may be technical, but the candidates' feelings about them expose one of the biggest fault lines between the Sanders and Clinton wings of the Democratic Party. To understand them is to appreciate the continuing impact of the 2008 financial crisis on this year's campaign.

Too Big To Fail

Sanders is winning points in the debate now because the living-will failures seem to prove his point that some banks are too big to fail and should be forced to shrink. But Clinton is right to have faith that regulators could successfully wind down a big bank if it was about to fail -- maybe not today but in a few years. Along with living wills, she points to requirements for banks to have more shareholder capital, new rules for transparency in derivatives trading and other parts of the Dodd-Frank law that were also designed to prevent another 2008 collapse.

Back then, regulators didn't have a clue about the extent of banks' interconnections. They didn't know who owed what to whom for derivative instruments like credit-default swaps owned by counterparties in different countries, or even how to value such swaps in a time of panic, when no one wanted to buy and everyone needed to sell.

The inability to value the assets of Lehman Brothers, and other institutions' reluctance to lend to Lehman when it desperately needed money, caused its collapse and the crisis to spread like a virus around the globe. The 2010 Dodd-Frank law is supposed to fix that.

Since then, progress has been made, though work also remains. The regulators -- the U.S. Federal Reserve and the Federal Deposit Insurance Corp. -- now require each bank's parent holding company to act as a so-called single point of entry. That entity's shareholders and unsecured bondholders must take all the losses in a failure. Banks can no longer rely on capital from overseas units, where governments are unlikely to let funds flow across borders until the dust settles.

This setup allows operating units to stay open so that customers can go to their ATM to get their money and bank branches can keep making loans. The living will lets regulators pinpoint which of thousands of subsidiaries need to be dissolved, sold or merged, depending on what caused the failure.

Banks have also streamlined their structures, cutting the number of legal units housing subsidiaries by 20 percent on average, making it easier to untangle a bank in a bankruptcy with fewer courts involved, and in fewer jurisdictions. The banks have reduced their borrowing levels in part by ceasing to trade securities and derivatives for their own profit. And all the banks have increased, on paper at least, their ability to quickly convert assets into cash.

The market has played a role, too. Many banks have sold riskier side businesses, such as overseas operations or commodities units, to reduce the need for equity capital, which protects taxpayers by absorbing losses but can lower returns and displease investors.

Three of the six largest banks in 2008 -- Citigroup, Goldman Sachs and Morgan Stanley -- are smaller now than they were before the crisis. Twenty-one global banks also agreed to wait 48 hours before demanding payment from a failing counter-party to a derivatives contract. This pause would give regulators time to move the contracts to a new, recapitalized entity and reduce the risk of panicky collateral demands.

So it's a disappointment that, given all these safeguards, the banks can't show how they can be safely dismantled in a crisis. This is the second time regulators have rejected living wills for the largest banks. (This week they flunked JPMorgan Chase, Bank of America, Wells Fargo, Bank of New York Mellon and State Street. One of the two regulators found the plans of Goldman Sachs and Morgan Stanley to be flawed, but they weren't rejected like the others. Citigroup won provisional approval from both agencies.) Doesn't that prove Sanders is right and it's time to bust up the big banks?

Not really. First, smaller banks aren't necessarily safer. In the 1980s, more than 1,000 savings and loans, each one minuscule compared with today's banks, failed due to self-dealing, speculation and lending at interest rates that were lower than the thrifts' borrowing costs. Sleepy regulators and political interference were rightly blamed for the debacle, which cost taxpayers more than $100 billion.

Nor is it a given that the big banks can never meet regulatory requirements for living-will adequacy. The latest rejections contain specific directions for getting to yes, including winding down derivatives portfolios, further streamlining legal structures and maintaining customer confidence in a crisis.

In October, we'll find out if the banks can correct the deficiencies. If regulators reject the banks' blueprints by the Oct. 1 deadline, the consequences could include restrictions on their businesses and requirements to raise more capital. (Big U.S. banks borrow heavily. On average, they borrow 94 cents for every dollar in assets, using international accounting standards.)

Of course, even if regulators accept the plans, what looks good on paper for an individual bank might fail in the real world. As Thomas Hoenig, the FDIC vice chairman, said, even the most credible playbook may not help if several large banks fail at once. But even he agrees that the key measure isn't size but a bank's importance in the daisy-chain of financial transactions in a crisis. Breaking up big banks now could require many more bailouts later.

In the meantime, regulators are on the case. Sanders, and voters, should let them finish the job.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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