The failure of ‘too big to fail’

For regulators, the solution to a major regulatory failure such as the Enron accounting scandal or the global financial crisis 10 years ago is simple: more regulation, preferably accompanied by expanded mandates, bigger budgets, new agencies and more international coordination. One objective of regulators after the financial crisis was protecting taxpayers from losses related to troubled financial institutions. The Financial Stability Board, which co- ordinates global efforts to promote financial stability, sent the G20 a letter July 4 stating that the largest banks are “subject to greater market discipline as a consequence of globallyagreed standards to resolve too-big-to-fail.” However, recent events in Italy suggests taxpayers remain vulnerable despite this assertion.

The approach to “too big to fail” was once simple. It was based on the concept of constructive ambiguity. By not being transparent on the criteria used to decide whether an institution would be bailed out, markets could never be sure what would happen in the event of an insolvency. This approach was turned on its head following the financial crisis, after which financial institutions were publicly labelled systemic either on a country or global basis. In other words, regulators believe financial difficulties at these institutions could pose a threat to broader financial stability. These institutions are now subject to more onerous regulatory requirements than other institutions including higher capital levels, living wills and stress testing.

But the designation has made clear to markets that these institutions are too-big-to- fail, inferring eligibility for bail- out. Regulators recognized the risk to taxpayers, which would have been hard to ignore given the public costs of the bailouts emerging f rom t he financial crisis. In Europe bailouts are considered to be a major contributing factor to the subsequent eurozone crisis. Regulatory standards have been i ntroduced to ensure the costs of bailing out systemically important banks is shared with shareholders and bondholders.

In late June, the liquidation of two insolvent small commercial Italian banks, the Veneto Banca and Banco Popolare di Vicenza, was announced with commitments by the Italian government of 17 billion euros of public funds. Shareholders and subordinated bondholders other than retail investors shared in the losses but senior unsecured bondholders and depositors were protected. The bail- out deal was approved by the EU Commission on the basis that action was not warranted by the EU resolution authority. The commission stated that there was no public- interest basis for EU action, such as a threat to financial stability. Financial markets celebrated.

The liquidation a nnouncement of the two Italian banks was followed up a week later by a “precautionar y r ecapitalisation” of Italy’s fourth- largest bank. State aid of 5.4 billion euros was injected into the bank Monte dei Paschi di Siena. Under the arrangement, which was also approved by the EU Commission, subordinated bond holders and shareholders shared in the burden by the conversion of junior debt into equity and the dilution of existing shareholders. Management compensation was capped, as if bad managers will perform better by being paid less. Despite some burden sharing, the costs of these interventions will add to Italy’s already bloated public debt, and ensure the nation is a top contender for a leading role in the next eurozone crisis.

Regulators may have been sincere in their desire to instill market discipline and protect taxpayers. But it is now clear that governments will make decisions based on political considerations, as they always have. Canada is proceeding to implement a comprehensive bail- i n framework to ensure shareholders and creditors of Canada’s six large banks are responsible for losses. The credit rating agency DBRS has stated that it will maintain its current assumptions on systemic support at least until the rules are finalized and sufficient bail- in debt has been built up. The regulations for the bail-in framework pre- published in June clearly state taxpayer exposure will be reduced as opposed to eliminated. Hence, the public costs of a bank resolution could still prove substantial and prompt significant financial stress on the federal government, similar to what happened in the eurozone crisis for governments that had been running deficits in both good and bad times.