When Bad Things Happen to Good Banks

By Karen Shaw Petrou

Virtually all of the debate during Dodd-Frank deliberations and that now under way to implement the new law focuses on ending “moral hazard.” Because big bad banks were rescued one way or another during the crisis, it is widely feared that the phenomenon of “too big to fail” remains as before. Many have suggested that the new law codifies bailouts because of the “orderly liquidation authority” it creates.

In fact, Dodd-Frank did as much damage to TBTF as it could without undermining an essential policy objective: ensuring that the U.S. government can still step in to support the financial system when events outside any institution’s control pose systemic risk.

Does this happen? Sadly, all too often — most recently on 9/11 and in Japan. Could it happen again? Of course it could.

The determined campaign to banish moral hazard results from its toxic role in causing the crisis. Bankers — yes, it wasn’t just bad nonbanks — relied on brokers who, free from moral suasion or effective controls, put borrowers into homes they hadn’t a prayer of affording. Securitizers sold the stuff to unsuspecting investors around the globe, enabled by complicit ratings agencies and hapless regulators at home and abroad.

Along the way, a lot of now-retired bankers furnished their offices with $10,000 trash cans and took home hundreds of millions, again seemingly immune to either moral suasion or internal control. There are, thus, more than enough cases of evildoing financial institutions, or at least the “big, dumb” ones cited by JPMorgan Chase’s Jamie Dimon, to go around.

But, this isn’t the whole story of systemic risk and it thus can’t be the single goal of reform. If all financial companies must fail all the time and, then, all counterparties — knowing and innocent — must blow up with them, the global financial system will be at far greater risk than ever when the next systemic crisis comes along.

In a recent address, Federal Reserve Gov. Daniel Tarullo rightly dissected systemic risks, differentiating those resulting from an almost casual disregard to consequences (the TBTF problem of evildoing bankers) from the catastrophes outside their control that threaten global finance. The Dodd-Frank debate to date reminds us only of Bear Stearns, AIG and Tarp. But what of the other systemic crises and what would have happened without the safety net?

On 9/11 we saw systemic risk in its most ruthless form. Because the global financial infrastructure was concentrated at the World Trade Center, the world payments system came perilously close to shutdown. Perhaps bankers were insufficiently cautious about operational risk, many costly lessons were learned that terrible day, but the events clearly were the result of vicious outsiders, not fat-cat bankers.

Disaster was averted for three reasons: Bankers and regulators spent sleepless nights rebuilding financial market infrastructure, the Fed threw a then-unprecedented amount of discount-window support into the market and counterparties stayed their hand because they knew regulators could stabilize the biggest banks. Was this TBTF? You bet, and a good thing, too.

Japan is another case of TBTF at work in ways even the most unsparing anti-bailout advocate should support. When the earthquake, tsunami and nuclear crisis hit at once, the Bank of Japan stepped in to flood the market with the funds needed to ensure orderly settlement and prop up — yes, that’s the word — the banking system. Had it not done so, counterparties would have had no choice but to fend for themselves to honor their own fiduciary duties starting a downward spiral of awesome systemic risk that central banks and regulators around the globe would have been hard pressed to avert.

Do these two cases argue for repealing Dodd-Frank and reinstating TBTF? Of course not. Without consequences, bankers will once again condone evildoing. Like it or not, the rewards are too large and regulators cannot be held to a standard of omniscience — no one can.

During the global financial crisis the Fed used not just the discount window, but also a series of rapid-fire rescue facilities to prop up TBTF institutions and their counterparties (global central banks included). This was essential at the time, but contributed to TBTF. Dodd-Frank thus rolled back the Fed’s power, but it rightly left it and the FDIC with remaining authority to step in the next time a liquidity panic threatens to shatter global markets. Critics have argued that this still is too much power to prop up TBTF, especially for foreign banks doing business in the U.S. However, further shackles on the Fed will force it to stay its hand in crises like 9/11.

What these systemic-risk cases, and many others across the span of financial history, do show is that regulators must be able to prevent panics and, if necessary, ensure orderly failure.

If we realize we live at risk of systemic events, which sadly we do, then financial systems must still be protected from events outside the individual control of institutions or regulators through backstop liquidity facilities like the discount window.

Another vital piece of ensuring systemic stability the next time systemic risk strikes is the orderly-liquidation power provided in Dodd-Frank. Some have proposed repealing this part of the law (Title II) on grounds that it authorizes backdoor bailouts of TBTF institutions. The FDIC is hard at work rebutting this in rules to implement this part of the new law, often citing the need to doom moral hazard as it does so. Much here is right and reasonable. Ending TBTF expectations that promote moral hazard is a worthy goal. But, as noted, systemic risk strikes not just evildoers and slackers, but also innocent bankers and counterparties, requiring regulators to intervene to stabilize institutions and markets in ways that can conflict with rules designed only to punish the guilty. Sometimes, liquidity support isn’t enough because financial crises go from panic, where short-term funding is vital, to asset fire sales that pose profound solvency problems that can be averted only when regulators step in.

Title II is entitled orderly liquidation authority for a reason: Congress rightly wanted the new law to wind down failed institutions, but to do so in a way that protects bystanders from collateral damage. A combination of Fed power to support market liquidity and this orderly shutdown process should ensure that markets are both stable and disciplined. But, if we press too hard to prevent any support during crises to damn moral hazard wherever it might lurk, we will create financial markets both less stable and even more undisciplined. Counterparties will rush to the exit and creditors will grab what they can before the fall, ensuring panic under stress that gives regulators little choice but to reinstate TBTF the next time around. Better now to finalize Title II with an eye to the next systemic risk no one can predict or, despite all the will in the world and the power of all the new rules, avert.

Karen Shaw Petrou is a managing partner at Federal Financial Analytics Inc.