The Big Fail

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

Sharing the Load

Dodd-Frank at least ensures that taxpayers will no longer bear the full burden of federal rescues. Ideally, banks themselves — and their investors — will bear some or all of the losses. Rules published by the FDIC determine how creditors will be treated during the liquidation of a large financial institution. If regulators instill a sense of greater market discipline on investors, the hope is that investors will become better watchdogs of bank risk-taking.

Spreading future bank losses across the capital structure worries bank investors like Andrew Fraser, investment director in fixed income at UK-based Standard Life Investments. He says three aspects unnerve bank investors here and overseas. First, if government support is reduced in the future, the risk of senior bondholders sharing in any losses going forward rises, leading to bank bonds trading at wider spreads. Second, next-generation securities issued by banks will have
more-complex structures, such as permanent-writedown language or conversion to equity when a bank’s capital breaches certain levels. “If bond investors are not comfortable with these new terms and conditions, funding from institutional investors could be more difficult to obtain,” Fraser says. And third, at least in Europe, more banks are turning to secured financing, like covered bonds. Covered bonds encumber more assets on the balance sheet, which could force lower recovery rates on unsecured bondholders.

However, changing the capital structure of banks so they can absorb larger losses is at least a partial remedy for bailouts. Contingent capital — debt that converts to equity when a systemically important institution heads into difficulties — provides an equity cushion in emergencies. It might not fit the investment mandates of investors in big-bank debt, like insurance companies, but this security type is starting to gain traction. In January, Rabobank issued a so-called CoCo, whose principal is written down if the bank’s equity-capital ratio falls below 8%. Similarly, a month later Credit Suisse sold debt that converts to equity if its core tier-1 capital ratio falls below 7%. In the United States, Dodd-Frank mandates that the Financial Stability Oversight Council produce a report on CoCos by mid-2012.

Some industry experts think banks simply need to hold more equity capital, above what Basel III requires. U.S. regulators are now determining the higher capital and liquidity levels that systemically important banks will have to meet. Anat Admati, a professor at Stanford University, suggests that 15% of non-risk-weighted assets would protect the financial system from recurring crises. Says CFO Lilek: “It would certainly be expensive to have that amount of capital, but it’s the right thing to do. Capital is there for the risks that you don’t know you have — the unforeseens.”

Too Far Gone?

None of the above measures would necessarily change the risky behaviors of large banks or forestall another global banking crisis. Nor would it preclude the United States from rushing to the aid of giant, crippled institutions. Put another way, the too-big-to-fail problem is still with us. Indeed, it could get bigger. Attorney Mutterperl notes that Dodd-Frank does not draw a line in the sand, as did Glass-Steagall, to prevent more banks from entering the too-big-to-fail fraternity. Banks got bigger when larger institutions merged with troubled banks during the financial crisis. Some regulators are now lobbying for an increase in the national deposit ceiling of 10%, but allowing banks to concentrate 15% or 20% of the country’s domestic deposits in one institution would create huge risks.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, believes that the Volcker Rule, which banned proprietary trading by banks, should have gone further and required financial institutions to carve out certain business lines. The existence of too-big-to-fail financial institutions “poses the greatest risk to the U.S. economy,” says Hoenig. Even if too-big-to-fail is framed not as a risk but as a promise, it would seem to be one that banking regulators can no longer afford to keep.

Vincent Ryan is senior editor for capital markets at CFO.

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