Advance bailout authority and capability is the third method, along with lender of last resort and guarantees, to deal with a financial crisis. In the United States, while we greatly limited the lender of last resort and guarantee weapons, we did not abandon them
altogether as we did with TARP, putting the new OLA resolution procedure, without the possibility of public support, in its place.
This is not sound public policy for designing a stable financial system. Suppose that all of our 8 G-SIBs were insolvent at the same time as a result of an operational failure due to a cyberattack or another form of terrorism? Do we really think the answer would be to put them all in OLA? How about just one, JPMorgan? In my view, a responsible Secretary of the Treasury or the President would not want to do so in either case, whatever the
moral hazard implications. And in extreme circumstances, would it not be better for the entire country, the taxpayers, to pay for a failure, with a high prospect of repayment, rather than impose the loss on creditors, which could include major institutions like pension funds and insurance companies (and ultimately the policy holders of such companies)?
So, if we don’t put our heads in the sand, we would design and fund such a capability in advance rather than have our Secretary of Treasury run into Congress at the last minute with a term sheet in hand. At the very least we would design the program in advance (even without funding) to make changes to the approach we used in TARP based on our experience with TARP. Key design issues for consideration would be: First, does it make sense to require all big banks to take assistance for fear of identifying the ones that are insolvent—who was really fooled by this? Second, should we really be giving assistance to every bank, or just systemically important ones? Third, could we combine capital
assistance with some degree of private loss, as the EU has the ability to do, even where we would not want to impose total loss? Fourth, how would we value the shares received in return for capital—would we want to assure a market rate of return for Treasury, or not?
Fifth, should we close out common shareholders entirely by nationalizing banks, as can be done in Japan, and presumably Europe? Sixth, could we impose more conditions on recipients, including wholesale replacement of top management? Seventh, should we be able to recapitalize banks and other financial institutions before they become insolvent, and if so how? Do we really want to think through these issues in the grip of panic, and where Congress is terrified by voting for an actual bailout under the gun? Some argue that having a plan, and particularly funding it in advance, will just encourage moral hazard. In my view, this concern can be met by deciding in advance what the criteria for its use would be—an extreme circumstance where no other alternative, including most importantly bail-in, is more attractive. And the keys to turn the program on could be very tough. Not only requiring the same actions that are needed to put an institution into OLA, votes by supermajority of the Fed and FDIC, and approval of the Secretary of the Treasury after consultation with the President. It could even include, if necessary, a joint
resolution of Congress. That procedure would be far better than what we now have. Who is fooling whom? The market will believe that bailouts will be used in extreme
circumstances even if the program is not on the shelf, so it is better to have a good one there than none at all.
And the advance funding would not necessarily involve government appropriations. As is the case with the EZ SRF, the funding could come from assessments on the financial sector, or as in the case of the EZ ESM, come from some government capital leveraged through borrowing authority with a government guaranty.
Notes
1. Id.
2. SRM Article 2(b),(c), available at http://eur-lex.europa.eu/legal-content/EN/TXT/?
uri=CELEX:32014R0806.
3. Rosalind Wiggins, Michael Wedow, and Andrew Metrick, The Single Resolution
Mechanism 1, 11 (2015), available at http://som.yale.edu/sites/default/files/files/001- 2014-5B-V1-EuropeanBanking-B-REVA.pdf.
4. George Zavvos and Stella Kaltsouni, The Single Resolution Mechanism in the European Banking Union 1, 39 (2014), available at http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=2531907.
5. SRM Regulation Article 27.7, available at http://eur-lex.europa.eu/legal-
content/EN/TXT/?uri=CELEX:32014R0806 (stating that the Single Resolution Fund
“may make a contribution … only where a contribution to loss absorption and
recapitalization equal to an amount not less than 8 percent of the total liabilities … has been made by shareholders, the holders of relevant capital instruments, and other eligible liabilities through write-down, conversion, or otherwise.”).
6. See, for example, Yasuyuki Fuchita, Richard Herring, and Robert E. Litan, Rock times:
New perspectives on financial stability 1, 15 (2012) (noting that before Dodd–Frank
“[s]ection 13(c)(4)(G) of the Federal Deposit Insurance Act had allowed, in the event of systemic risk, for capital injections, debt guarantees, and other support for insured depository institutions that go beyond the principles of least-cost resolution.”
However, “Section 1106(b) of Dodd–Frank modifies that section of the Federal Deposit Insurance Act … to require that assistance in the event of systemic risk be provided ‘for the purpose of winding up the insured depository institution …’ thus disallowing open bank assistance transactions.”).
7. See, for example, SRM Regulation Article 27.6(b), available at http://eur-
lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014R0806 (stating that under
certain circumstances, when certain liabilities are excluded from bail-in measures, the Single Resolution Fund may be used to “purchase instruments of ownership or capital instruments in the institution under resolution, in order to recapitalize the
institution”).
8. ESM, Frequently asked questions on the European Stability Mechanism (ESM), Mar. 2, 2015, http://www.esm.europa.eu/publications/index.htm (accessed Mar. 21, 2015) (henceforth “ESM FAQ”).
9. European Stability Mechanism, ESM reaches target level of 80 billion in paid-in-capital (May 1, 2014), available at http://www.esm.europa.eu/press/releases/esm-reaches- target-level-of-80-billion-in-paid-in-capital1.htm.
10. European Stability Mechanism, ESM direct bank recapitalisation instrument adopted (Dec. 2014), available at http://www.esm.europa.eu/press/releases/esm-direct-bank- recapitalisation-instrument-adopted.htm.
11. ESM Guideline on Financial Assistance for the Recapitalization of Financial Institutions, Articles 3.2 and 4.3, available at
http://www.esm.europa.eu/pdf/ESM%20Guideline%20on%20recapitalisation%20of%20financial%20institutions.pdf 12. ESM Guideline on Financial Assistance for the Recapitalization of Financial
Institutions, Article 4.3.
13. European Council, ESM direct bank recapitalisation instrument (Jun. 20, 2013), available at http://www.consilium.europa.eu/council-eu/eurogroup/pdf/20130620- ESM-direct-bank-recapitalisation-instrument/.
14. European Stability Mechanism, ESM direct bank recapitalisation instrument adopted (Dec. 2014), available at http://www.esm.europa.eu/press/releases/esm-direct-bank- recapitalisation-instrument-adopted.htm.
15. European Banking Authority, EBA consults on criteria for determining the minimum requirement for own funds and eligible liabilities (Nov. 2014), available at
https://www.eba.europa.eu/-/eba-consults-on-criteria-for-determining-the-minimum- requirement-for-own-funds-and-eligible-liabilities-mrel-.
16. See, generally, Articles 102 through 126.1.
17. Article 102–1.
18. Hideyuki Sakai, Overview of the Japanese legal framework to resolve a systemically important financial institution in insolvency, Proceedings in Japan 1 (2012), available at http://www.law.harvard.edu/programs/about/pifs/symposia/japan/2012-
japan/bingham-h-sakai-paper.pdf.
19. Kei Kodachi, Japan’s orderly resolution regime for the financial firm, Nomura Institute of Capital Markets Research 1 (2014), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379907; Article 98.
20. Article 102–1.
21. Kei Kodachi, Japan’s orderly resolution regime for the financial firm, Nomura Institute of Capital Markets Research 1 (2014), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379907.
22. Article 105.
23. Kei Kodachi, Japan’s orderly resolution regime for the financial firm, Nomura Institute of Capital Markets Research 1 (2014), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379907 (noting that the
original systemic risk exception did not permit the use of public funds to underwrite a holding company’s share issuance).
24. Financial Services Agency, Determination on the recapitalization of the Resona Bank, Ltd (2003), available at http://www.fsa.go.jp/news/newse/e20030610-1.html.
25. Kei Kodachi, Japan’s orderly resolution regime for the financial firm, Nomura Institute of Capital Markets Research 1 (2014), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379907.
26. Deposit Insurance Corporation of Japan, Bank nationalization and re-privatization of Japan (2010), available at
http://www.dic.go.jp/katsudo/kokusai/roundtable/5th/2010.3.18f.pdf.
27. Ashikaga applies for TSE listing, Japan Times (2015), available at
http://www.japantimes.co.jp/news/2013/07/31/business/financial-markets/ashikaga- applies-for-tse-listing/#.VRr6oeFLOT8 .
28. Article 126–2(2)(i)-(iv).
29. Kei Kodachi, Japan’s orderly resolution regime for the financial firm, Nomura Institute of Capital Markets Research 1 (2014), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2379907.
30. Article 126–19(1).
31. Article 126–22(1).
32. Article 126–2(1)(i)-(ii).
33. Article 126–39(1).
34. Article 125(1).
35. Masahiro Kawai, Asian monetary integration: A Japanese perspective (ADBI Working Paper Series, 2014), available at
http://saber.eaber.org/sites/default/files/documents/2014.04.18.wp475.asian_.monetary.integration.japan_.pdf 36. Id.
26 Conclusion
This book’s central concern is the fundamental stability of our financial system upon which the viability of our economy, and ultimately our polity, rests. This stability depends on the ability of the government, and especially our central bank, the Federal Reserve, to deal with panic runs—contagion—as it did during the financial crisis of 2008. The failure to do so in the future could put our country’s survival at risk. It could lead not only to a depression but could result in revolt—challenges to our political system itself. Our world power would be dealt a severe blow. The reserve status of our currency could well come to an end. A world crisis set off by a US depression would be a threat to our national
security. Bad monetary policy might destroy a country in years, but bad lender of last resort policy can destroy a country in weeks.
In the aftermath of the crisis, those that saved our country during the crisis—the Fed, FDIC, and Treasury—were demonized as bailing out Wall Street. As a result the powers of the government to deal with contagion in the future have been severely constrained. This is not a popular subject to complain about—anyone, whether in industry or in
government, seeking to restore and even improve our powers to deal with contagion will again be attacked as bailing out Wall Street. But given the stakes, this is no excuse for silence.
In the 2008 financial crisis we witnessed a severe plunge in real estate prices that led to significant losses for financial institutions exposed to residential mortgages and
commercial real estate. This book demonstrates that it was “contagion,” not
“connectedness,” that was the most potentially destructive feature of that crisis and that contagion remains the most virulent and important part of systemic risk still facing the financial system today. Connectedness is the possibility that the failure of one institution would bankrupt other institutions directly overexposed to them, resulting in a chain
reaction of failures. Contagion is an indiscriminate run on financial institutions that can render them insolvent due to fire sales of assets necessary to fund withdrawals.
The book shows that connectedness was not the problem in the crisis. No significant Lehman counterparties were rendered insolvent by Lehman’s failure, with the exception of the Reserve Primary Fund where investors only lost a few pennies on a dollar. And no significant counterparties would have been rendered insolvent by AIG’s failure. This is because sophisticated financial institutions routinely manage counterparty risk by limiting their capital exposure, demanding adequate collateral, or hedging. Yet Dodd–
Frank is largely premised on the idea that connectedness was the major problem in the crisis. This is reflected in Dodd–Frank’s requirements for central clearing of over-the- counter derivatives (swaps), net exposure limits for banks, and the designation of banks and other financial institutions as systemically important financial institutions (SIFIs) and therefore subject to heightened supervision by the Federal Reserve.
However desirable these Dodd–Frank policies may be, the real problem in the crisis was the contagion that smoldered before Lehman’s failure and broke out in a full blaze
afterward. The losses from contagion and the impact on our economy and country would have been much worse but for heroic efforts by the Federal Reserve to expand its role as lender of last resort, by the FDIC to expand the amount of its insurance, by the Treasury to temporarily guarantee the money market funds, and by the government under TARP to make capital injections in some major banks that were insolvent, or on the brink of
insolvency. But the powers of the Fed, FDIC, and Treasury were barely adequate to the task. While the lesson of the crisis should have been that Congress must strengthen their powers, its actual response was to weaken them.
The Federal Reserve was created in 1913 to stem such panics, which were rife in the nineteenth century and culminated in the panic of 1907, through acting as the lender of last resort. As the book describes, the United States came late to the party in creating a central bank. This was largely because of the bad political odor left by our early
experiment from 1791 to 1832 with the First and Second National Banks. These were both full-scale federal banks (private in form but government controlled) with broad powers to lend commercially, not just to other banks. But these two National Banks could and did come to the aid of illiquid state banks by modulating use of their ownership of state bank notes to demand specie redemptions from the state banks. The National Banks came to an end in 1832 when newly reelected President Jackson, who had campaigned against these banks as too powerful and too federal, refused to back reauthorization. This bad odor is still with us. The current attack against the Fed’s power as lender of last resort is often premised on the idea that the federal government should not make any loans to the private sector, whether those loans are made to commercial establishments, banks or other financial institutions.
As a result of the anti-bailout sentiment following the 2008 crisis, the Fed’s power as lender of last resort was significantly restricted by the Dodd–Frank Act, particularly as a lender of last resort to nonbanks under Section 13(3) of the Federal Reserve Act. Having a strong lender of last resort for nonbanks is increasingly important, as nonbanks have issued approximately 60 percent of the estimated $7.4 to $8.2 trillion in runnable short- term liabilities in the financial system.
The Fed can now only lend to nonbanks under a broad program, only with the approval of the Secretary of the Treasury, only if the nonbanks are solvent, and only with
heightened collateral requirements. The Fed must also make prompt disclosure of any loans to nonbanks to leaders in the Congress. Discount window loans to banks can also no longer be used to fund nonbank affiliates of banks like broker-dealers. Moreover the Fed knows that any future use of its powers a lender of last resort will be controversial, further threatening its independence and powers. This may inhibit its willingness to act in the future, even within the scope of its newly restricted legal powers.
It is eye opening that the Fed ranks last in its lender of last resort powers to nonbanks as compared to its peer central banks, the Bank of England (BoE), the European Central Bank (ECB), and the Bank of Japan (BOJ). None of these institutions differentiate their lending powers between banks and nonbanks or are prohibited from lending to single
nonbanks. None have as demanding disclosure policies as the Fed. The ECB has what amounts to constitutional independence, and while the BoE and BOJ require Treasury approval or request for emergency lending, both operate in parliamentary democracies where the government also controls the Parliament. The biggest threat to Fed
independence is the Congress (which can create and destroy the Fed), and which the Administration (even if of the same party) cannot control.
The Fed’s main partner in fighting contagion during the 2008 crisis was the FDIC, which was created in 1933 during the Depression. The fundamental idea behind its creation, which remains valid today, was that depositors in banks would not run if their deposits were insured. During the 2008 crisis the FDIC expanded the amount of
insurance—granting unlimited insurance to transaction accounts and higher limits for other accounts. The FDIC also guaranteed the issuance of senior debt. In addition the Treasury stepped forward to temporarily guarantee the money market funds, where the contagion blaze first broke out. These FDIC powers were taken away by Dodd–Frank, and, in the case of the Treasury, by the earlier TARP legislation.
Some argue that the old powers to fight contagion are no longer necessary because we have put in place new ex ante regulations to prevent future contagion—namely enhanced capital requirements, new liquidity requirements, and new resolution procedures, what I have termed the two wings and prayer approach. Capital and liquidity requirements, the wings, are ex ante policies designed to prevent contagion, not to deal with it if it does occur. It would be foolhardy to believe we can completely avoid contagion by adopting such policies. Capital requirements only apply to banks and a few specific nonbanks (e.g., the three nonbank SIFIs, for which the requirements have not yet been determined), and could never be at a high enough level to assure short-term creditors that capital would not be seriously eroded by the fire sale of assets in a crisis. In addition the very methodology for designing capital requirements, whether through Basel requirements or stress tests geared to risk, is under serious attack.
New liquidity rules also only apply to banks, whereas short-term liabilities are
increasingly held outside the banking system. Liquidity requirements seek to assure that banks have liquid assets to cover withdrawals in a run. But they are based on dubious assumptions about the withdrawal rates of different kinds of bank funding, and
ultimately cannot avoid the need of a central bank to act as a lender of last resort when
“private” liquidity fails. At best liquidity requirements can buy some breathing room for the central bank to determine what to do, but the fact of the matter is that it must act very quickly.
New resolution authority under the Orderly Liquidation Authority (“OLA”) in Dodd–
Frank is the prayer. First, its use is not assured. It only comes into play if a financial
institution on the brink of insolvency is determined to be a threat to the financial stability of the United States. Second, while procedures are being designed with the objective of making sure no short-term creditors of banks and other subsidiaries of financial holding companies, like broker-dealers, would lose money in an OLA procedure (as opposed to equity and longer term debt), these procedures may not prove effective or credible enough to stop runs on still solvent institutions. Short-term creditors may flee these