Fifteen Eighty Four

Academic perspectives from Cambridge University Press


Protecting our banks from the next financial crisis

Johan A. Lybeck

Broken Piggybank. Photo: Jacob Edward via Creative Commons.

As a result of the recent financial crisis, a number of measures have been undertaken to make a repeat less likely and to facilitate recovery and resolution of failing banks should a (systemic) financial crisis nevertheless occur again.

Foremost among measures to increase the resistance of banks to financial stress are the Basel III rules for increasing the quality and quantity of capital as well as the introduction of liquidity coverage ratios, implemented by the Dodd-Frank legislation in the United States and by the CRD IV package in the European Union. Additional measures to improve stability are enhanced supervision, in particular of the Too-Big-To-Fail (TBTF) banks, and a focus on stringent stress testing of banks.

The Dodd-Frank Act places restrictions on the ability by US banks to own hedge and equity funds and forbids banks’ proprietary trading, a half step back to the Glass-Steagall division into banks and investment banks. In Europe, new rules are forcing banks to ring-fence their core activities from riskier investment-bank activities.

Whether the measures taken will be sufficient is hotly debated.

“Some see the failure to break up the TBTF banks as an indication that next crisis may be similar to the last one.”

Some see the failure to break up the TBTF banks as an indication that next crisis may be similar to the last one. Others think that the curtailment of banks’ activities will instead lead to a crisis beginning in some part of the less-supervised so called shadow banking system.

Be that as it may, measures have also been undertaken to change and hopefully improve the manner in which a banking crisis is resolved. In the United States, the Orderly Liquidation Authority (OLA) under Title II of the Dodd-Frank Act enhances the powers of the Federal Deposit Insurance Corporation (FDIC) to seize not only banks but also bank holding companies and other systemically important financial institutions, as well as its powers to impose losses on holders of unsecured debt on top of those of shareholders. Under the Single Resolution Mechanism (SRM) in Europe, an EU-wide single resolution authority is created and a gradually communalized single bank resolution fund is established for the Euro area countries; some member states such as Sweden and Germany have already established industry-financed stabilization funds of their own. The United States has, however, rejected the use of pre-funded resolution funds, preferring a Pay-As-You-Go financing of bank liquidation.

A trait common to OLA and the European Bank Recovery and Resolution Directive (BRRD) is to severely restrict the possibility to bail out banks with tax payer money. The new US rules also severely curtail the ability by the Federal Reserve to utilize its powers under Section 13(3) of the Federal Reserve Act to lend to individual non-bank institutions (such as Bear Stearns and AIG during the last crisis), invoking “unusual and exigent circumstances.” In the future, such facilities must be broad-based and directed at providing liquidity to a group of financial institutions rather than individual firms.

To my mind, the restrictions imposed on the regulatory authorities’ tool-kit may severely curtail their ability of resolving the next financial crisis, implying unnecessary costs not only to financial firms and the financial sector but unnecessary output losses and unemployment in the real economy. In my book we find, in particular, that the use of tax payer money is an inevitable feature of successful interventions.

A credible resolution authority depends on having the Treasury (i. e. the tax payer) as a last resort. This implies that instead of curtailing bail-outs, we should try to deduce how to use tax-payer money in an effective and equitable way, simultaneously guaranteeing their eventual return to the investors with a decent profit.

Similarly, bailing-in of unsecured senior bond holders and uninsured deposits was a significant factor behind creating additional uncertainty and financial instability in the past crisis.

One of the main findings of my book is that the United States, after Dodd-Frank, presents a consistent framework of resolution where some minor things need to be changed, as indicated in the body of the book. Europe, on the other hand, is in a total mess.

Whereas in the United States, the three “legs” of a banking union (supervision, resolution, and deposit insurance) are in place, the European Union has introduced a Single Supervisory Mechanism (SSM) housed in the European Central Bank but without communalizing the other two “legs”. A Single Resolution Board is created but without adequate (common) resources and without the vital tax-payer funded backstop.

Common rules for deposit insurance have been enacted but without the necessary common Deposit Insurance Fund. Either the European Union decides, within a very short period of time, to implement a true European Banking Union or it would be preferable to reintroduce supervision and resolution at the national level.

About The Author

Johan A. Lybeck

Johan A. Lybeck is the author of The Future of Financial Regulation: Who Should Pay for the Failure of American and European Banks? (2016). He has worked as Managing Director of Fi...

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