The Big Fail

Despite the reach of Dodd-Frank, the "too-big-to-fail" dilemma lives on.

During the Latin American debt crisis, when major banks held sovereign debt that was trading at pennies on the dollar, U.S. regulators took a very measured approach, Brown says. They let the largest banks work out their problems over an extended period, rather than forcing them to recognize losses if they had to sell the debt immediately, he says. “In the next crisis, multiple institutions will experience problems simultaneously, and regulators need flexibility to work in a manner that is not terribly hasty.”

Keen to Intervene

Time is not something that regulators want to give failing banks in the next financial-market meltdown. Indeed, globally there is a concerted push to get national regulators to intervene sooner. Urs Rohner, vice chairman of the board at Credit Suisse, says regulators need much stronger powers to step in early. If a critical situation arises at a bank, said Rohner in a speech last spring, “authorities need the power to replace the senior management of the firm, order an increase in capital, order financial restructuring, and identify any parts of the firm that remain systemically vital and transfer those to third-party acquirers or, if necessary, to a bridge bank.”

“Regulators might want to step in and arrange marriages before the FDIC is called upon,” agrees Accretive Solutions’s Lilek. “Government could work to have transactions without FDIC assistance — if they mandated that the institution just needed more capital sooner,” she says. “The outcomes might reduce the costs to the FDIC insurance fund, which is a cost to the bank and ultimately a cost to the customer.”

Yet the early-intervention strategy is no panacea. It presents at least two problems, especially in the case of money-center banks:

First, spotting a bank that is headed for a catastrophic failure is not easy. Last fall, the Bank for International Settlements (BIS) released a study that showed how the consolidated financial reporting of international banks can easily hide developing trouble spots. Problems often originate on banks’ local-office balance sheets, says the BIS. To accurately measure a risk like short-term funding, for example, regulators would need data that breaks down a bank’s consolidated balance sheet into local offices. But no data exists with this level of detail, “or is likely to any time soon,” the BIS says.

Second, even if U.S. regulators do catch problems early, they may not have the resolve to take action. “The tool kit that [Dodd-Frank] gives regulators is pretty powerful,” says Bill Mutterperl, a partner at Reed Smith and former vice chairman of PNC Financial Services Group. “The question is whether they will have the prescience to recognize a systemically risky situation and whether they will have the political will to deal with it.”

Consider Continental Illinois National Bank and Trust Co. In 1981, it was the largest commercial and industrial lender in the United States. Three years later, it became the largest bank resolution in U.S. history (later surpassed by Washington Mutual). Problems at the $45 billion bank were evident at least two years before its demise, according to the FDIC study. Yet regulators failed to step in, leading to a capital infusion by the FDIC and an unlimited guarantee of all deposits. According to the FDIC paper, the will to dictate direction to the bank’s executive board was lacking.

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