Too big to fail

Fright simulator
How to deal with a collapsing bank under the DoddFrank rules
Nov 12th 2011 |
NEW YORK

| from the print edition

http://www.economist.com/node/21538164

OF ALL the questions unleashed by the bankruptcy of MF Global, a broker, the most important is whether America is prepared to deal with a bigger collapse, on the scale of another Lehman Brothers. The Dodd-Frank reform law creates an alternative to letting a systemically important firm go bankrupt, known as resolution. But it also prohibits bailouts: shareholders and creditors must bear losses. The Economist simulated the failure of a global bank at its Buttonwood Gathering on October 27th in New York (a video can be seen here). Larry Summers, a former treasury secretary and once Barack Obamas top economic adviser, was joined by five other ex-officials and a prominent bank lawyer to play the parts of officials at the Treasury, the White House and regulatory agencies on a Friday afternoon in April 2013. The group was confronted with a teetering, $1 trillion bank-holding company called New Jefferson. Without their intervention, it would not open on Monday, an event guaranteed to send markets into free fall. The participants soon found their options narrowing. There was no prospect of a private consortium propping up New Jefferson, as had happened with Long Term Capital Management, a hedge fund, in 1998.

Improvements to derivatives markets since then have made it easier for banks to sever ties to a troubled counterparty. Bankruptcy, the Lehman-was-really-fun-lets-do-that-again option, as Mr Summers put it, was rejected, despite its political appeal. In this section Drought warning The road to self-deception Fright simulator Contact sports Asias rice bowls Fee high so dumb Exports to Mars Reprints Related topics Federal Deposit Insurance Corporation Lawrence Summers Dodd-Frank Wall Street Reform and Consumer Protection Act Economic policy Financial rescue plans That left Dodd-Franks resolution authority. Jay Powell of the Bipartisan Policy Centre, a think-tank, who developed much of the simulation, said remarkably few market participants know that the law prohibits bail-outs, virtually guaranteeing that some creditors will take losses. As that realisation dawned, many may rush to shed exposure to a troubled bank, and perhaps many banks. Panic might ensue. John Dugan, a former comptroller of the currency, played the role of chairman of the Federal Deposit Insurance Corporation (FDIC) and said resolution actually made four options possible.

First was outright liquidation, tantamount to bankruptcy.

Second was receivership: New Jefferson would be split into a good bridge bank with the soundest assets and secured creditors, and a bad bank with impaired assets and unsecured creditors. The FDIC would run the bridge bank until it found a buyer. But like a melting ice cube, the banks franchise value would rapidly shrink as depositors, counterparties and staff all left. Both options were rejected. The third option was to sell the bridge bank to another big bank. The combined entity would reopen for business on Monday morning, providing maximum continuity to creditors, customers and counterparties and minimum contagion. But it came laden with problems: a massive, new toobig-to-fail bank would come into being which would require waivers on Dodd-Franks 10% ceiling on any firms share of total financial-system liabilities, and on various capital requirements. The fourth option, recapitalisation, would convert the claims of unsecured creditors to equity in the bridge bank, much as occurs during a prepackaged Chapter 11 bankruptcy filing. This too had problems: sorting out the claims could take a week or more, reviving the melting-ice-cube problem. Bondholders who woke up to find themselves stockholders might sell their shares, and the shares of any other banks, aggravating contagion. Although the officials found none of the options appealing, they ultimately chose recapitalisation while keeping the door open to a sale. (The complexities of co-ordinating with other countries, a subject of new international standards released this month by the Financial Stability Board, were glossed over.) All were very aware that the straitjacket of Dodd-Frank might make contagion unavoidable. That does not necessarily make it a bad law. Mr Summers compared it to a prohibition on paying ransom, which makes kidnappings harder to resolve but also, hopefully, less probable. By restricting bail-outs, youre making New Jeffersons less likely, he said.