In the aftermath of the Wall Street bailouts, nearly everyone agreed that one of the greatest priorities for reforming the financial system was to make sure that this wouldn't happen again.
"Never again will the American taxpayer be held hostage by a bank that is too big to fail," Barack Obama told the American people.
The primary mechanism put in place to avoid another round of bailouts is called "resolution authority." The idea is that instead of keeping failing financial giants alive, regulators will swoop into a failing financial institution, fire the executives, cram down the creditors and wipe-out shareholders.
The dire prospects of falling into resolution are supposed to discipline managers to avoid excessive risk and incentivize bondholders to monitor risk at banks. The combination of management and bondholder risk awareness should improve performance and decrease systemic risk.
That's the theory, anyway. One problem with this theory is that no one knows how resolution authority will actually operate. It isn't bankruptcy but we don't know quite what it is. We don't know when, exactly, it can be invoked. Once it is invoked, we do not know how the process will work or what the outcome will be. It's a black box inside of a black box inside of a black box.
But even if we somehow got resolution authority right—perhaps by carefully modeling it after existing bankruptcy law—it's not clear that regulators will be able to invoke it. After all, the law itself requires regulators to consider the effects of resolution on the stability of the financial system. That is a ready-made excuse for not 'resolving' a large and complex financial institution.
Now Peter Boone and Simon Johnson have raised a new problem: banks seem to be growing into global giants that will make it impossible for national regulators to invoke resolution authority.
The resolution authority does not cover global financial activities. In fact, it cannot, because no legislature, including the U.S. Congress, can pass a law that determines what will happen in another country’s legal system.
This has major implications for the next time that the financial system melts down. And bankers are well aware that there will be a next time—[JP Morgan Chase CEO Jamie] Dimon himself told the Financial Crisis Inquiry Commission that there is a crisis “every five to seven years,” which is a completely sensible assessment of how the world’s credit system functions. Before the next crisis comes, however, all a bank has to do to escape the resolution authority is to grow so large that it is vital to not just the U.S. economy, but the entire international financial system. If one of these mega-banks goes under, the government will have no choice but to step in and provide full creditor protection. The resolution authority will effectively be meaningless.
When corporate executives want to protect themselves against potential hostile takeovers, they devise “poison pill” defenses—legal instruments that make it harder for outsiders to get board seats or bring pressure to bear on managers. The hole in this resolution authority is the ultimate poison pill under the new regulatory regime. Already, Dimon and other leading bankers are taking steps to make their banks bigger and more intrinsic to the world economy. It’s a loophole so brilliant and so dangerous that it should take your breath away.
This will have seriously perverse consequences. As the credit markets figure out that the largest banks are immune to the risk of resolution and will continue to be bailed out if they fail, the big banks will find credit easier to access. This will give them an advantage over smaller competitors.
It's likely they'll use their access to cheap credit to acquire would-be competitors. What's more, it will encourage excess risk taking because the bond market will not be able effectively exercise discipline. Even if bankers wanted to be prudent, they'll lack the bond-market signaling mechanism that would let them know when they've taken on too much risk.
In short, this isn't just about banks building themselves out of resolution authority. It's about building themselves into the next crisis.
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