By Bernard Kellerman
The world is on a slowly spinning countdown to the next financial crisis, and questions are being asked as to how the banking system will hold up.

The major causes of concern once again are the so-called “too big to fail” banks. These are — in theory, if not in reality — so large and so closely interconnected that if one was to fail, it would risk bringing the rest of them with it.

So, the question is better expressed as: Are we ready for a big bank failure in a time of recession?

The answer is, nobody knows.

When the G20 Financial Stability Board collated a list of 29 banks that were too big to fail in 2011, one originally on the list — with a level of capital that made it one of the strongest banks in Europe as at June 2011 – was forced into nationalisation before the list was ready to be published.

Unhappy anniversary

This is a time of anniversaries for the global financial crisis (GFC). Topping the list is the arrival of the sixth anniversary of Lehman Brothers bankruptcy on 15 September 2008, the date when a US investment banking failure started to get a lot worse.

What the past few years have made clear is that bank regulation needs to overcome national borders, just as the world’s biggest banks have become global enterprises.

During the GFC these global giants, seen as too big to fail, were propped up by huge injections of taxpayers’ funds and other government assistance.

The term “too big to fail” neatly describes the view that a national government or central bank would intervene to prevent the failure of a large, complex financial institution to avoid destabilising its financial sector and the “real economy”.

Expectations of government rescues potentially give rise to lower funding costs and other advantages — notably that irresponsible risk management will end with the institution being “bailed out” by taxpayers.

It’s been made quite clear that taxpayers across the globe will not look kindly on a second round of major bailouts of financial institutions, backed by austerity measures and rising unemployment — only to see bankers pay themselves huge bonuses.

This is the moral hazard risk.

With that in mind, the G20 tasked an international body, the Financial Stability Board, with solving the problem of the “too big to fail” banks. The FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions includes steps such as allowing national financial regulators sufficient scope and coverage, adequate resolution authority and powers, and encouraging the use of cross-border cooperation agreements.

However, despite the widespread agreement in principle between leaders of G20 nations and trading blocs, divergence in application of the rules is becoming apparent at a regional, even national, level.

Banks are still too big to fail, the only difference is that somebody else will pay to avoid failure, and that somebody else is the creditors.

In the northern hemisphere, there has been a far greater take up and implementation of bail-in provisions that impose losses on shareholders and unsecured creditors prior to bank failure, in order to protect taxpayers’ money.

S&P suggested that the recent adoption of the Bank Recovery and Resolution Directive (BRRD) in Europe demonstrated policymakers have made significant strides to ensure taxpayers will not be called on again to bail out failing banks.

The BRRD requires prior haircuts of a bank’s equity holders and creditors up to 8 per cent of adjusted liabilities and equity, or 20 per cent of risk-weighted assets, before a potential bailout can take place.

In the Eurozone, Germany attempted to seize “first mover” status by introducing its own Bank Reorganisation Act, which came into force on 1 January 2011.

“The principal aim of the new German Bank Reorganisation Act is to destroy the implied state guarantee for system-relevant banks on the support of the German taxpayer,” Dr Hendrik Boss, a partner in the Munich office of law firm Taylor Wessing, wrote in a note to clients.

Boss added that the new law increases the overall risk to creditors and shareholders in the case of financial distress of any German bank, regardless of whether such a bank is systemically important or not.

This is achieved by shifting the important and viable assets into a “good bank” while the impaired assets would be held in a “bad bank” with the expectation that creditors and unsecured subsidiary debt holders would be “bailed in” — that is, have their debt converted to equity — in an attempt to stabilise the operation.

(Later that year, the Franco-Belgian “too big to fail” bank Dexia was put through the process, in what became the first test of the new co-operative approach to dealing with a distressed bank – see below.)

These moves led Reuters to report in April that the risk that creditors, rather than taxpayers, will bear the brunt of rescuing a bank in trouble has been recognised in the first credit ratings given to 18 of Europe’s biggest banks by new ratings agency Scope.

The company, set up in Berlin in 2002, started credit ratings two years ago and aims to offer a new approach for corporate bond investors that typically rely on the three major ratings firms – Moody’s, S&P and Fitch.

“Banks are still too big to fail; the only difference is that somebody else will pay to avoid a failure, and that somebody else is the creditors,” Sam Theodore, Scope’s managing director for financial institutions, told Reuters.

He said this “privatisation of bank rescues” reflects an attempt by regulators to ensure banks are not guaranteed state support in a crisis. According to the International Monetary Fund’s Global Financial Stability Report, however, banks still benefit from implicit state support, especially in Europe.

Scope, in line with most other commentators — from the banks themselves and their lobby groups, to rival ratings agencies to the US Federal Reserve — said all the banks it rated were in stronger credit shape than before the crisis, with higher levels of capital and liquidity and lower risks in their businesses.

Dodd-Frank and Volcker

Another anniversary worth mentioning is that it is four years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was legislated in the US.

Dodd-Frank explicitly bans the bailout of an insolvent bank by the US government and severely limits the Federal Reserve’s ability to provide liquidity support to a failing bank prior to its holding company being placed into receivership as part of its orderly resolution authority.

While the major ratings agencies seem pleased with the move, the risk of a taxpayer-funded bank bailout is far from resolved.

Peter Schroeder, writing for the online US political news service, The Hill, noted that, four years on, just over half of the 398 required pieces of legislation have been voted into existence.

The arguments levelled by both sides made clear that the passage of time has done little to close the partisan gulf between the parties on whether the law, and the reams of new regulations it created, were the proper response to the financial crisis.

The too big to fail debate has continued to play out in the halls of Congress, with lawmakers from both parties airing scepticism that the bailout era has truly ended, despite insistence from the administration and the financial sector that the matter has been addressed, Schroeder reported in August.

While Dodd-Frank supporters say the law gives regulators the power to step in and wind down ailing institutions instead of bailing them out, Republicans questioned the efficacy of that power, according to Schroeder. They said the “orderly liquidation authority” given to regulators by Dodd-Frank remains dangerously untested.

“The partisan feuding continued even as many of the largest pieces of the landmark law have fallen into place,” Schroeder wrote. “Regulators have completed work on several of the law’s most significant, and most contentious pieces, such as the ‘Volcker Rule’ that bars banks from engaging in certain kinds of speculative investments that do not benefit their customers.”

This was one type of irresponsible banker behaviour identified in the fallout from the GFC, where large banks were using depositors’ funds to trade securities in their own right – often trading against the best interest of their own clients.

Asia-Pacific remains unconvinced

While officially embracing the FSB’s Key Attributes, most countries in the Asia-Pacific region have taken a cautious approach to recent G20 resolutions and bail-in initiatives.

“This is likely due to a perception that the reform agenda has been driven by countries outside the region, from where the global financial crisis emanated,” according to the ratings agency Moody’s investor service.

Even the G20 Asia-Pacific countries, which are in the process of implementing the FSB’s key attributes, do not seem ready to give up the bailout tool, nor are many jurisdictions in the region rushing to accept senior creditor bail in.

Policymakers, including in Organisation for Economic Cooperation and Development countries such as Australia, Japan, and Mexico, may view bailing out a failing systemic bank as  less costly than forcing a senior creditor bail in.

It is time to debate whether these ideas are worthwhile.

In Australia, public discussion of bank resolution, and especially bail-in provisions, has been noticeably circumspect.

The Financial System Inquiry, which aims to come up with a government-led blueprint for the financial system over the next decade, has highlighted the lack of statutory bail in as a gap relative to international standards. But the authorities appear to see both positives and negatives in bail-in provisions: the benefits of addressing moral hazard and too big to fail need to be weighed against the overall costs to the economy.

So far Australian regulation has approached the problem of too big to fail by measures to reduce the risk of the failure occurring. Local banks have been made subject to more oversight and higher capital requirements, according to a note to clients from major law firm King, Wood and Mallesons.

In New Zealand, the RBNZ now requires all banks with more than NZ$1b in retail deposits to implement systems that enable an Open Bank Resolution process. If a bank fails, it is placed under statutory management and closed. An assessment is made of the bank’s liabilities. If losses cannot be covered by shareholders and the bank’s available capital, then in addition a proportion of depositors’ funds is set aside and frozen for the purpose. The bank re-opens next morning. Depositors can then access most of the money in their transaction and on-call savings accounts and conduct their normal business.

Ultimately, the bank may go into liquidation, or be bought by either the government or one of its private sector competitors.

Too big to jail

Five years after the meltdown, the potential for a criminal prosecution of any of those involved in the events leading up to the collapse of financial markets in 2007 and 2008 has faded as the statute of limitations for financial fraud ran out in the US.

In a series of articles looking at the crisis five years on from the Lehman Brothers bankruptcy on 15 September 2008, the US Center for Public Integrity noted that none of the chief executives of the large banks had been indicted.

Indeed, all of the CEOs of the 25 largest non-bank subprime mortgage businesses were back in business in the financial services sector and unlikely to see the inside of a courtroom, far less a cell.

“This is the greatest white-collar fraud and most destructive white-collar fraud in history and we have found ourselves unable to prosecute any elite bankers,” said Bill Black, an economics and law professor at the University of Missouri and author of The Best Way to Rob a Bank is to Own One. “That’s outrageous.”

The hurdle, Justice Department officials say, is that to prove a crime, they must prove intent. That means if the government wanted to bring charges against any of the CEOs of the companies that led the nation to financial disaster, prosecutors would have to prove to a jury beyond a reasonable doubt that these individuals intended to commit fraud.

US Attorney General Eric Holder appeared to confirm that view in 2013 when he said he was hesitant to criminally prosecute big banks because he was afraid of the damage such a move could do to the economy.

“When we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy… that is a function of the fact that some of these institutions have become too large,” he said during a Senate Judiciary Committee hearing in March.

Bernard Kellerman is a business and banking journalist with 16 years’ experience, including four years writing for and editing CFO magazine.

This article was first published in the September 2014 issue of Acuity magazine.