The US has suffered three severe financial crises in the past 40 years, each driven by excessive risk taking, particularly in real estate. Regulators had plenty of authority to rein in the abuses but failed to do so. This is partly because the US regulatory system is fragmented and politicised and the Dodd-Frank financial reform law made it worse. But even if we had the ideal regulatory structure, we could not rely on regulation alone to control excesses in the financial industry that too often lead to crises.
To end the boom-bust cycles and accompanying panics, we do need smarter, more effective and less politicised regulation – but it is also critically important to impose stronger marketplace discipline on financial institutions, particularly the largest that were previously regarded as too big to fail.
Dodd-Frank authorises the Federal Deposit Insurance Corporation and the Federal Reserve to collect – through a process mislabelled “living wills” – a great deal of information from major financial institutions. The twin goals are to ensure that they are organised and operated in a way that reduces their risk of failure and, if they do fail, to allow them to be resolved quickly with as little systemic impact as possible.
This process holds promise but has has a shaky start due to distrust between regulators and regulated and a lack of guidance on what information is needed. Clearer and franker communication is essential.
When regulators finally gather the information needed to understand the biggest institutions, they must develop a plan to ensure these are structured and operated in a way that will allow them to be re-organised or to fail without creating panics that cripple the economy. The plan must be simple, practical and credible to convince markets it will be employed when needed.
Requiring big institutions to increase their common equity capital to breathtaking levels – say above 9 per cent of assets – is not the answer. It lowers returns on equity to a point where banks will not be able to raise enough capital and will shrink their balance sheets, impeding growth – as is happening in Europe. Moreover, equity holders, even when they perceive the risks to be excessive, cannot impose the same discipline on management as creditors. Finally, equity holders may gain from taking risks and so are more tolerant of risk than creditors.
A more effective form of market discipline would be to require large financial institutions to issue, at least annually, both long-term senior and subordinated debt. The total long-term debt should be more than enough, when coupled with a bank’s equity and reserves, to cover any reasonably conceivable losses the institution might incur.
If the institution faced insolvency, the FDIC would put the institution into a “bridge bank” that would operate under FDIC control with new management and directors. The bridge bank would continue to serve depositors and borrowers, leaving the equity and long-term debt behind in a receivership with no guarantee of recovery. The bridge bank would be privatised as soon as possible.
If total equity and long-term debt were set at 20 per cent of assets, it is hard to imagine the FDIC, much less taxpayers, ever incurring losses on the failure. If a bigger cushion were desired, a 5 or 10 per cent hold-back on uninsured depositors could also be imposed.
This plan would not only protect the FDIC and taxpayers against losses in the event of failure, it would also impose discipline making failure much less likely. A bank would be required to issue senior and subordinated long term debt on a regular basis. A risky bank would have to pay higher interest and ultimately might not be able to issue debt, which would curtail growth and force it to adopt a new strategy.
This plan is simple, predictable and will help end financial panics. It removes management and directors on whose watch the crisis arose and imposes losses on shareholders and sophisticated creditors, resulting in greater market discipline to help regulators do their job. It ends “too big to fail” and puts large and small banks on a level playing field. It is a plan whose time has come.
William Isaac, former chairman of the Federal Deposit Insurance Corporation, is global head of financial institutions at FTI Consulting. Richard Kovacevich is former chairman and chief executive of Wells Fargo & Company. The views expressed are their own.
Get alerts on Opinion when a new story is published