Fed's Dudley signals a shift toward bank reform
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. 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 con- firms 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 DoddFrank'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.
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.