To-Big-To-Fail and Systemic Risk: What Did They Come From and What Do They Mean?

1. To-Big-To-Fail and Systemic Risk:What Did They Come From and What Do They Mean? By Dr. Robert A. Eisenbeis Chief Monetary Economist Cumberland Advisors April 14, 2009

2. Too-Big-To-Fail Has Been With Us For a Long Time and Isn’t Confined to Banks

3. Where Did It Come From for Banks? • FDIAct of 1950 gave FDIC ability to provide financial support through loans or direct acquisition of assets when the “continued operation of a bank is essential to provide adequate banking service: • In May 1984 government supported Continental Illinois Bank • Discount loans • Credit from a syndicate of lenders put together by then Fed Chairman Paul Volcker • Fed agreed to meet all of Continental’s liquidity needs • FDIC guaranteed 100% of debt • FDIC Provided $2 billion in assistance • Money center banks created an unsecured facility of $5.3 billion at instigation of Fed • Assistance was provided to prevent its failure on several grounds • Contagion fears • Fear of disruption to payments and settlement systems • Effects on correspondent banks • CofC Todd Conover indicated that government would not let top 11 banks fail • This was birth of TBTF

4. Systemic Risk Exemption • FDICIA 1991 • Instituted Prompt Corrective Action • Least Cost Resolution – resolve problems at “least possible long-term loss to the deposit insurance fund.” • Introduced systemic risk exemption- FDIC could violate LCR if it “would have serious adverse effects on economic conditions or financial stability; and.... [doing so] would avoid or mitigate such adverse effects.” • After FDICIA TBTF morphed into the “systemic risk exemption”

5. What Is Systemic Risk?We Now Know Less Than We Did! • What was systemic policy trying to prevent? • Runs on banks – traditional concern • Contagion – information asymmetries • Banking system collapse – • Continental bank • Correspondent bank collapse – counterparties • Jobs would be lost – (St Germain) • Threat to large dollar settlement system and network effects • Fear that Infra structure of short term money market and OTC derivatives would not handle failure of significant counter party and might cast doubts on the soundness of other counter parties (Bernanke on Bear Stearns) • Panic due to loss of confidence (Warsh) • Risks to system due to failure of “highly interconnected” firm • “Unpredictable consequences of a failure for broader financial system” (Geithner) • Reaction of counterparties of other firms that might come under future government control (Kohn on AIG). • AIG was large, complex and interconnected whose failure would impose losses on counterparties and also endanger the entire world’s financial sector (Bernanke-Morehouse Univ, today)

6. What Institutions Should Be Considered Systemically Important and How Do We Limit the Moral Hazard That It Brings? • List of candidates is long and goes far beyond banks to include • auto companies, cities, airlines, banks and insurance companies. • But we don’t have a workable definition of “systemically important” but rather we have an adjective that is used to justify any action that policy makers deem necessary. • Without a definition that can be applied ex ante, we have both uncertainty, and • An incentive for all large firms to gamble that they too will be included. • We have little as taxpayers in the way of ex post accountability

7. Is Systemic Risk Regulator the Answer? What would the powers be? • Closure doesn’t solve the problem • US can’t grant authority to close an affiliate or subsidiary chartered in another country • Because of this how would AIG have been resolved differently? • Critical issue is dealing with holding companies • Who would have responsibility? • Fed • Treasury • Shared responsibility • Should some institution be charged with macro systemic risk responsibilities? • How would conflicts be resolved? • What are the implications for Fed independence?

8. Consider 2002-2004 • Fed kept interest rates low as way of getting us out of recession • Housing was engine of growth • People warned about housing bubble • If Treasury had been systemic risk regulator could it have forced the Fed to change policy? • If Fed had been regulator would it have behaved differently? • Formal systemic risk responsibility is a losing game on two accounts

9. How to Limit Systemic Risk and TBTF Subsidies • Make failures isolated events – if any firm can’t fail and be reorganized then it should be restructured • Limit excessive leverage • Focus on capital that would be at risk • Only two types of liabilities in banks – insured liabilities and liabilities capable of absorbing losses. • Abandon risk-based capital concepts • Address consolidated entity issue • Address information asymmetry problems • Address issues of complexity • Charge complex institutions for the cost of examination and supervision (this is a form of risk-based insurance premiums) • Consider restricting derivatives above first degree • Consider restricting naked swaps • Put all derivatives on exchanges structure like futures exchanges • Make unwinding scenario part of examination and supervision • Forget systemic risk regulator concept and just make sure there are no monetary policy and fiscal imbalances