Another day, another round of nail-biting debate about financial reform. On Thursday, the US finalised its mammoth regulatory overhaul, the Senate approving it in a long-awaited final vote.
But, even as the end looms, new evidence has emerged that voters are uneasy. A Bloomberg poll for example, shows half the US public question whether this bill will improve finance; instead, many fear the reforms will end up protecting Wall Street at the expense of Main Street.
And while the banking industry itself vehemently disagrees, the crucial issue is the question of “too big to fail”. On paper, this bill is supposed to remove this, by including provisions to ensure banks are better run and better supervised – and thus less prone to collapse in the future. The bill also creates a resolution regime, to provide a way of handling a failed bank without sparking a systemic meltdown.
But what is still unclear, even amid all the legislation, is whether this system will be robust enough to really prevent more big bank failures. Hence the lingering suspicion that taxpayers could soon end up back on the hook; and hence all that simmering anger.
Is there any solution? One fascinating idea now provoking a chorus of behind-the-scenes debate among regulators and central banks is the concept of a so-called “bail-in”. This idea, mooted by Credit Suisse in an essay this year, argues that in essence the best way to handle a crisis at a large, systemically important bank is to force creditors – not taxpayers – to swallow losses if disaster strikes; and, more importantly, to do this while the bank is still operating as a going concern, so it does not collapse – and cause Lehman-style havoc.
Banks would, in effect, do this by copying bankruptcy codes in other areas of business and issuing subordinated debt that could be wiped out, or turned into equity, if an institution became insolvent. But this would be done at the discretion of regulators rather than lawyers.
In some respects, this echoes another set of ideas on the table around contingent capital, or “cocos”. This suggests banks should issue bonds that would automatically convert into equity when certain triggers were breached, a long time before the point of potential collapse.
But there is a crucial distinction: the “bail-in” scheme does not use automatic triggers, but instead lets regulators decide when to wipe out creditors, just before the moment of collapse (or “one minute to midnight”, as traders say). That would thus prevent banks from trying to game complex triggers, and investors from endlessly speculating about when triggers might be activated.
Some banks hate this whole idea, fearing it would push up funding costs. But to my mind, at least, there are numerous merits to the scheme. Since it is designed to prevent a bank from going into bankruptcy, it offers regulators a way to deal with a failing cross-border bank without grappling with the nightmarish question of reconciling different national bankruptcy codes. Better still, large banks have such fat cushions of subordinated debt that these should easily be able to absorb losses in a crunch, without the use of taxpayer funds.
Credit Suisse, for example, reckons the top-20 US banks have about $3,400bn of debt that could theoretically be used for debt-for-equity swaps in a crunch. And even if some of that was ring-fenced (because, say, it has to be used to protect core liabilities), Credit Suisse reckons there is still at least a $2,000bn-odd cushion of debt in the US – and perhaps even more in Europe – that could absorb losses.
However, another big attraction of the scheme is its simplicity. Unlike the coco idea, the “bail-in” concept does not involve complex triggers; nor does anybody need to contend with the law courts. On the contrary, the concept of getting creditors – not taxpayers – to foot the bill is simple enough for even a journalist or politician to grasp. Better still, it reinforces basic market principles and a concept that has been shamefully ignored in recent years: namely that creditors have a responsibility to conduct real oversight.
So could the bail-in idea fly? That remains unclear. Some European regulators and central banks take the idea very seriously, and predict that it could be adopted by the Basel Committee in some form over the next year. In the US, some senior officials, such as Jeffrey Lacker, president of the Richmond Federal Reserve, are also warming to the idea of imposing haircuts on creditors. But that hefty US reform bill does not currently include any reference to “bail-in” schemes, and it remains an open question whether there is wider support for going down this path.
I hope this idea does catch on. It is not a perfect solution to the too big to fail problem; but it is probably the best idea out there right now. And perhaps the most feasible way to create what has been lacking recently: a sense of justice – and real market discipline – in the banking world, that might assuage voter anger.
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