Counterfactuals

How new rules for banks in US and the UK could have prevented the global financial crisis

December 11, 2012
December 11, 2012

Bank regulators in the United States and the United Kingdom have described a new framework (pdf) for global financial firefighting. The idea is to make it easier to bring failing global banks in for a soft landing without taking the rest of the world’s banking infrastructure down, too.

The framework builds on Dodd-Frank, the 2010 law that overhauled US financial regulation, and reform efforts in the UK. While global banks have been a reality for quite some time now, only recently have regulators been given the powers they say they need to deal with the fallout from the collapse of such a large institution without saddling taxpayers with losses or crunching the financial system.

The biggest difference for regulators is “resolution authority,” the ability and resource to run insolvent investment banks through a kind of sped-up bankruptcy process. The second is that regulators say they are focused more on systemic global problems. In 2008, when the crisis started with banks in the United States, regulators in the UK were reluctant to extend much financial help, aiming to protect their own jurisdiction; but as the crisis spread national boundaries started to matter a lot less.

Here are some cases where the new rules might have helped during the crisis.

Lehman Brothers would have been broken up

When Lehman Bros. began running into liquidity problems in the summer of 2008, thanks to plentiful investment in over-valued mortgage bonds, federal regulators didn’t want to spend money on a rescue, insisting on a “private sector” solution. The failing company was shopped to a variety of customers who weren’t interested in buying the company. Finally Barclay’s, the British bank, seemed willing to purchase the failing company’s assets. But the UK’s Financial Services Authority put the kibosh on the deal, refusing to waive a rule that required Barclay’s shareholders approve the financing of Lehman, which would have taken months at a time when action was needed within hours. Lehman failed, sparking the financial crisis; later, Barclay’s would purchase Lehman’s US business.

What would be different now? The Federal Deposit Insurance Corporation (FDIC), which is a regulator as well as guarantor of deposits, would have already taken the axe to Lehman, to separate out its assets from its liabilities. At least according to this FDIC paper (pdf, p. 15; parsed in more detail here), the result would have been that Barclays would have bought the bank. Even allowing some skepticism for the ease of hindsight, there’s a case that Barclay’s and the British regulator would have been more comfortable taking on Lehman’s on-going business after the FDIC eliminated more of the risk associated with Lehman’s bad assets by wiping out unsecured creditors and equity-holders.

AIG would have had to plan its own funeral in advance

In the case of AIG, regulators took up the exact opposite of their strategy on Lehman. They used government money to bail out the company directly because of its place at the center of a global network of financial derivatives. A particular problem was that the insurer’s primary regulator, the Office of Thrift Supervision, was focused on AIG’s US bank subsidiary but had no idea what executive Joseph Cassano was doing at AIG Financial Products in London. Which, it turns out, was cooking up an insolvent balance sheet that then-Federal Reserve official Tim Geithner called “a bag of shit.”

What would be different now? Regulators and firms are working together on funeral plans. Banks large and complex enough to fall under resolution authority will be required to come up with a plan to shut down their companies in the event of failure and submit them to their public supervisors. That means that regulators will be required to understand the firm as a whole, not just a bank subsidiary.

Citigroup wouldn’t have had a liquidity crisis imposed on it

Let’s turn to the report of the Financial Crisis Inquiry Commission, which details the 2008 crisis (pdf, p. 380):

[Citigroup’s] various regulators watched the stock price, the daily liquidity, and the CDS spreads with alarm. On Friday, November 21, the United Kingdom’s Financial Services Authority (FSA) imposed a $6.4 billion cash “lockup” to protect Citigroup’s London-based broker-dealer. FDIC examiners knew that this action would be “very damaging” to the bank’s liquidity and worried that the FSA or other foreign regulators might impose additional cash requirements in the following week. By the close of business Friday, there was widespread concern that if the U.S. government failed to act, Citigroup might not survive; its liquidity problems had reached “crisis proportions.”

What would be different now? Both regulators have less reason to take precautionary measures that hurt overall liquidity, like this lock-up, if they fear a firm is soon to go under.The FSA did something that made sense—for the UK, at the time—by ensuring that if Citi went under, the London subsidiary would retain capital that could cushion the blow within its jurisdiction. Obviously, Citi didn’t fail, but the cash lockup certainly hurt its efforts to survive and broader financial stability. Under the new resolution authority, both the UK and the US have promised a top-down strategy that will, ideally, keep subsidiaries operating in the event of a failure.

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