In past weeks, we’ve expressed numerous reservations about the new systemic-risk resolution regime. Now, we’ll posit another: it will be flat-out impossible to assess a risk-based premium on systemic institutions to offset the huge taxpayer back-stop provided for them in the Treasury/FDIC plan. Advocates argue that the rescue facility won’t cost any of us a nickel because the big boys will pay premiums to fund it. However, a new study argues that a systemic-risk premium for twelve U.S. banks alone would cost between $100 billion and $250 billion a year. Since they aren’t the only firms that would trigger Treasury’s systemic-risk threshold, the cost of the program could be astronomical. From this, we go back to our initial argument: let systemic-risk firms fail.
The study that took us aback comes from a trio of academic and Fed economists, released earlier this week by the Bank for International Settlements. We aren’t whiz-kiddy enough to evaluate the complex methodology deployed in the study, although we liked it a lot from what we’re able to tell. Instead of using quarterly balance-sheet data or historical analyses, the study relies on real-time data derived from the credit-default swap and equity markets. This is, the authors argue, a macro-micro way to evaluate the probability of default of twelve large banks and, based on it, the paper comes up with the risk-based premium noted above.
The $100-250 billion range is breath-taking and, as noted, it’s just for the twelve big banks of 2008. Applying this methodology to other firms that would come under the Treasury systemic-risk regime – AIG anyone? – would bring the number to galaxy- spinning dimensions. Even if the methodology is all wet and the estimated premiums are too big by half, the resulting risk-based premium for U.S. systemic-risk institutions is still dizzying. Further, the premium is based on systemic-risk protection for only fifteen percent of a covered bank’s liabilities. Extend the premium to the unlimited coverage possible in the Treasury bill, and the sky is literally the limit.
This may be an academic exercise – it was certainly a highly academic study. However, it’s one with immediate policy implications. The Treasury systemic-risk resolution bill is skimpy on the details of who would pay for it, but it is premised on provisions that require financial companies that could trigger the systemic-risk wire to do so. In recent comments, FDIC Chairman Bair has put a little more meat on this outline, stating strongly that the new resolution-funding mechanism will not rely on either banks outside it or taxpayers. However, no one has yet sized out what this new premium schedule could look like until this BIS study. Even if we liked the systemic-resolution proposal (which we don’t), the BIS calculations are daunting. If Congress proceeds with the new resolution regime without careful, advance consideration of the real cost of so generous a safety net, the bills to come will make the trillions pledged to date in the current rescue look trivial.