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Ending Government Bailouts: As We Know Them (April 16, 2010) E-mail

Highly readable treatment of highly troubling issue
Posted on April 16, 2010

Ending Government Bailouts: As We Know Them, Editors: Kenneth Scott, George Shultz, and John Taylor, 338 pp., Hoover Institution Press, Stanford University

http://www.ababj.com/images/stories/keith_leggett.jpgReviewed by Dr. Keith Leggett, senior economist in the Office of the Chief Economist at the American Bankers Association. Prior to joining ABA, Dr. Leggett was an Associate Professor of Economics at Davis & Elkins College.  Dr. Leggett’s responsibilities at ABA include analyzing the structure and performance of the banking industry and monitoring conditions in the macroeconomy and in the credit markets. You can read about his credit union blog, and ABA’s new economics blog, below, following his review.

After reading Ending Government Bailouts: As We Know Them, I am firmly convinced that we will never end bailouts—but we may get to the point of making bailouts tolerable.

http://www.ababj.com/images/stories/bookreview_keith_leggett.jpg The book is a compilation of papers presented at a December 2009 conference. Given the current political debate about ending too-big-to-fail, this book is very timely.

The book’s organizing theme is articulated in the first paper, by former Secretary of State George Shultz: “How do we make failure tolerable?” The collected papers are divided into four subject areas.

• Part I deals with the dangers of bailouts and calls for tightening the limits on the activities of banks with access to the Federal Reserve’s discount window.
• Part II examines the nature of systemic risk.
• Part III looks at reforms that financial institutions can implement, whether or not required by governmental agencies.
• Part IV explores two alternative mechanisms for dealing with failing systemically important financial firms–bankruptcy versus resolution authority.

In Chapter 2, Paul Volcker, former Federal Reserve Board chairman, writes that large systemically important institutions need to be dealt with in a manner where they are not rescued and where there is not relief to stockholders or even bondholders.

Volcker analogizes that this should not be an emergency ward or recovery ward in a hospital, but rather a funeral parlor.

The papers by Volcker, former Treasury Secretary Nicholas Brady, and Shultz all call for curbing the activities of systemically important institutions. Brady believes that we need to erect impenetrable firewalls between deposit-taking institutions and the “shadow banking system.” Volcker argues that institutions that have access to the Fed’s safety net should not be allowed to conduct proprietary trading or to manage hedge funds. These prohibitions would cause these institutions to become smaller–which he believes is a move in the right direction.

I strongly recommend the paper by John Taylor, “Defining Systemic Risk Operationally,”  one of the book’s editors, a noted academic, and former Treasury Under Secretary. Taylor writes that it is essential that policymakers have a clear operational definition and measure of systemic risk. After reviewing the literature, Taylor concludes that systemic risk is not well-defined. He worries that if we move forward with reform proposals “we will make things worse by enshrining an inoperative concept.” Taylor believes that efforts should be focused on defining and measuring systemic risk.

Another interesting paper by Stanford University’s Darrell Duffie outlines alternative approaches for the automatic recapitalization of financial institutions that could pose systemic risk to the economy. One approach is for these institutions to issue distress-contingent convertible bonds. These bonds would convert into equity if a systemically important financial institution fails to meet certain trigger capital requirements. The other alternative is for mandatory rights offerings to existing shareholders at a price well below the current market price when a financial institution fails to meet certain stipulated liquidity or capital requirements. If the price is sufficiently low, existing shareholders are likely to subscribe to new equity issuance. However, Duffie cautions that these alternatives are unlikely to stop a liquidity crisis once it starts.

Two papers look at the issue of wind-down plans. The basic premise is that systemically important institutions should define in advance how they can be efficiently shut down, restructured, or sold off without causing systemic risk. By adopting a “living will,” the institution makes it clear to creditors and counterparties that losses may be imposed on them. The adoption of a wind-down plan may simplify the corporate structures of these institutions, and it potentially reduces the risk exposure of these firms.

As envisioned, firms must submit their wind-down plans in advance for regulatory approval. If the plan is unacceptable, regulators must have the authority to compel a firm to simplify its structure or spin-off activities. Otherwise, the exercise of preparing such a plan is senseless and a costly checking of boxes. However, the Wharton School’s Richard Herring, in his paper, notes that “international corporate complexity presents a formidable challenge to an orderly unwind” of systemically important financial institutions. The chapter provides a glimpse to cross-border obstacles. To overcome these obstacles, there is a need for ex ante agreements on loss-sharing arrangements. Without such an arrangement, regulators will ring fence the assets they control.

On the other hand, Stanford’s Joseph Grundfest in Chapter 8 writes that wind-down plans may be a good idea, but face implementation challenges. Wind-down plans cannot anticipate every contingency. He views that the likelihood that they will be implemented as planned during a crisis is modest; because of incomplete contracting and renegotiation risk. Governments can unilaterally change the terms of the plan. To illustrate the point about incomplete contracting and renegotiation risk, he compares the wind-down plans to Tiger Woods’ prenuptial agreement. Grundfest also contends that these wind-down plans are meant to limit systemically important financial institutions from engaging in tax or regulatory arbitrage rather than to facilitate a smooth wind-down.

The last section of the book looks at alternative mechanisms for dealing with systemically important institutions–resolution versus bankruptcy. William Kroener III, former FDIC general counsel, outlines the pros and cons of FDIC-style resolution authority. Among the advantages of a bank resolution model are: 1. speed of resolution; 2. relatively low transactions costs; and 3. higher probability of ownership and management being placed in the hands of a capable successor. However, the disadvantages include: 1. a less clear and predictable set of rules on creditor priorities; 2. an essentially political decision on whether the situation involves systemic risk; and 3.  a bias towards finding systemic risk to minimize disorder and disruption.

Kroener further argues that the existence of an ex ante fund for systemic resolutions, as proposed in the House and Senate bills, will create a stronger bias “to be overly quick in determining that ‘systemic’ situation exists.”

I would thoroughly recommend this book. The papers are well written—and you don’t have to be a policy wonk to understand the issues.

Like this? You can also read other ABA BJ book reviews here.


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• Keith Leggett blogs regularly on credit union issues. He has spearheaded many aspects of the ABA credit union fight for years. 

• ABA’s Office of the Chief Economist recently launched its own blog, under the direction of Chief Economist James Chessen.

• ABA member banks can subscribe to member-only economic updates here.

[This article was posted on April 16, 2010, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2010 by the American Bankers Association.]

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