There is a time-honoured way of protecting taxpayers from picking up the bill for the failure of a systemically important financial institution. It involves central banks and finance ministries pressing a better capitalised bank to absorb the ailing business through an arranged merger. Yet it is becoming clear that this tool of crisis management can no longer be put to use, raising questions about the authorities’ ability to stabilise the financial system in a crisis.

Nothing better illustrates the point than Bank of America’s $16.7bn payment last month to resolve allegations that it misled investors in its mortgage-backed securities. This was a curious form of justice. The allegations arose mostly from the activities of Merrill Lynch and Countrywide, which BofA acquired in 2008. Of course, if the rules of the game had been set by the Federal Reserve and the US Treasury these pre-merger transgressions might not have been punished, which would have raised a different set of questions about justice, or the lack of it. But because the Department of Justice, the Securities and Exchange Commission and six state attorneys-general had a splendid opportunity to put all four feet in this potentially lucrative trough, the rules conformed to a different logic. The message for the financial community – as with the punishment of JPMorgan Chase for the misbehaviour of Washington Mutual before it was absorbed by the bigger bank in 2008 – is that due diligence on a crisis merger would now take too long to be practicable.

The same applies in Europe, though for different reasons. The experience in the UK with Lloyds’ acquisition of HBOS showed how the hurried acquisition of a weak bank could destroy a strong acquirer. Royal Bank of Scotland was similarly damaged by parts of ABN Amro.

Equally important is the problem of banks that are not only too big to fail, but too big to rescue because their liabilities are so big that the government lacks the fiscal capacity to stand behind them. The devastation wrought by oversized banks in Ireland and Iceland offers a stark lesson.

Big bank mergers in the advanced countries are dead. Yet since the collapse of Lehman Brothers in 2008, the disadvantages of conventional bankruptcy have been all too apparent. In the US, government bailouts have been outlawed by the Dodd-Frank legislation. So new sources of finance have to be found to recapitalise systemically important banks that are in trouble.

The current consensus is that this should come from “bailing in” creditors so that they share the losses, while mechanisms for orderly resolution, or unwinding, are put in place. As Charles Goodhart, emeritus professor at the London School of Economics, has pointed out, creditors facing greater risk will either demand a higher return or place funds with banks in the form of deposits so as to be immune from bail-in. To prevent this, the authorities are likely to mandate that banks hold a required buffer of loss-absorbing capital over and above their equity. The unanswered question is what would happen when the buffer of loss-absorbing debt is used up.

In the US, the Federal Reserve and the Federal Deposit Insurance Corporation this month rejected as inadequate the living wills of the biggest American and European banks. These are a central mechanism for the orderly resolution of banks that fail in a crisis. Despite Europe’s attempt to move to banking union, its Single Resolution Mechanism leaves considerable discretion to national authorities.

A paradox at the heart of this new approach to systemic crises is that bailing in creditors is likely to have far-reaching effects because, unlike a bailout, it will inflict losses on other systemically important financial institutions. The Dodd-Frank Act looks to the banking industry to meet any losses in excess of what equity and debt are capable of absorbing. This is a recipe for panic.

When governments fear that a systemic crisis could precipitate a depression, they may find ways of returning to the bailout habits of the past. In 2008-09, that proved messy. Yet the impossibility of arranged mergers in the US and UK, and the untried regulatory structure, suggests that when that happens crisis management may prove even messier.

This article has been amended to reflect the settlement with US authorities related to activities at BofA, not just Countrywide and Merrill Lynch


Letter in response to this column:

A reckless banking industry is a drag on the economy / From Prof. Anat Admati and Mr Martin Hellwig

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