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Fed’s Dudley Signals a Shift Toward Bank Reform

By Simon Johnson
November 25, 2012 6:30 PM EST
Illustration by Tim Lahan
Illustration by Tim Lahan

This is now the standard line from Wall Street lobbyists: Don’t worry about “too big to fail” financial institutions because the Dodd-Frank Act fixed the problem.

The implication is that Congress should relax and not push any additional changes, such as capping the size of our largest banks in a meaningful way or forcing them to simplify their legal structures. If regulators lack support on Capitol Hill, they won’t try as hard.

On Nov. 15, resistance to this industry view came from a surprising place: a speech by William Dudley, the president of the Federal Reserve Bank of New York. That institution isn’t usually associated with strong pro-reform positions, yet Dudley was unexpectedly forceful on three points.

First, he made clear that too big to fail remains with us. Some very large financial institutions receive implicit government subsidies in the form of downside protection (or at least the market’s perception that such protection exists). This insurance is free of charge and allows them to borrow more cheaply, and presumably encourages them to become even larger. Now, whenever someone questions the existence of these dangerous subsidies, I will cite Dudley’s speech.

Living Wills

Second, I was struck by Dudley’s admission that the recently completed first round of living wills -- potential liquidation plans drawn up by major financial institutions --has been far from satisfactory. I encounter industry lawyers who assert that living wills provide a clear road map for winding down systemically important financial institutions. I will also refer these people to Dudley’s speech, in which he confirms that living wills have accomplished no such thing.

“We are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society,” Dudley said.

Still, the New York Fed president says that living wills are an “iterative process” that will take some time to work. My view is that they are a sham, meaningless boilerplate and box checking.

Third, Dudley is also perceptive on the difficulty of applying to global banks the “orderly liquidation authority” of Dodd-Frank’s Title II. The general idea is simple: Allow the Federal Deposit Insurance Corporation to manage the “resolution” of large financial institutions in the same way it has handled the failure of banks with insured deposits since the 1930s.

The insurmountable obstacle -- as critics have pointed out for at least three years -- is that there is no cross-border framework or process for handling the failure of big financial institutions. Different countries have different rules, and powerful people in those countries -- U.K. bankers or French civil servants -- like it that way.

Here’s the heart of the matter with regard to over-the- counter derivatives, as stated by Dudley in the nuanced language of a central banker.

“Certain Title II measures including the one-day stay provision with respect to OTC derivatives and other qualified financial contracts may not apply through the force of law outside the United States, making orderly resolution difficult.”

In plain English: When a global financial behemoth is on the ropes, the legal mechanisms for an FDIC-managed resolution won’t work outside U.S. borders. JPMorgan Chase & Co. (JPM), Citigroup Inc. (C), Bank of America Corp. and perhaps some others are literally too global to fail in an orderly manner.

I also have three serious reservations about Dudley’s comments.

Clear Language

First, he says that banks “hold” capital. This is the wrong verb to use because it encourages relatively uninformed readers to think of capital as an asset, rather than what it really is, a liability, or shareholder equity.

The words of an influential official such as Dudley matter because they pervade popular commentary and can lead to great linguistic and conceptual confusion, for example on Capitol Hill. They also encourage the illusion that higher (equity) capital requirements will somehow hurt the ability of banks to provide credit; in fact, more equity makes any financial system safer and more resilient over the cycle.

We should expect our central bankers to speak clearly and explain issues in terms that people can understand. Dudley is calling for more equity, relative to debt, in the financial system. He should use plain English to make this essential point.

Second, the logic of Dudley’s speech draws the reader to the idea that megabanks should greatly simplify their legal structures, which would make any kind of liquidation easier. At the largest financial institutions, the relationship between business units and legal entities has become hopelessly complicated, creating a major difficulty in any insolvency or resolution process. Disappointingly, while Dudley flags the general issue, his language is opaque and he doesn’t press for immediate action -- despite the industry having no good reason for maintaining this degree of complexity.

Finally, Dudley calls on proponents of breaking up our largest banks -- so they become small enough and simple enough to fail -- to explain in more detail how this could be done and what the precise implications would be.

There is great irony here. During the debate over the Dodd- Frank Act in spring 2010, genuine reformers such as Senator Ted Kaufman of Delaware pressed the administration on the likely inadequacy of their “living wills” and “orderly liquidation authority” approach.

Did the New York Fed or any other officials think creatively with Kaufman and his allies about complementary approaches, including a binding cap on size and leverage? The answer is no. Led by the Treasury Department, they slammed the door on all alternatives.

As Kaufman said at the time in a speech on the Senate floor, why is the burden of proof on those who want to return to the proven statutory and regulatory approaches of the past?

The onus should be on those who, after a devastating financial crisis, continue to tinker at the margins of the failed regulatory framework.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

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Today’s highlights: the editors on saving Spain’s banking system and on why the U.S. should allow natural gas exports; William D. Cohan on Jon Corzine’s tenure at MF Global; David Kornblau on regulating markets like the nuclear power industry.

To contact the writer of this article: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net

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