Fed's Dud­ley sig­nals a shift to­ward bank re­form

The Pak Banker - - Front Page - Simon John­son

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.

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