To-Big-To-Fail and Systemic Risk:
What Did They Come From and What Do
They Mean?
By Dr. Robert A. Eisenbeis
Chief Monetary Economist
Cumberland Advisors
April 14, 2009
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Too-Big-To-Fail Has Been With Us For a Long Time and Isn’t
Confined to Banks
Industry/Company
Year
Type of Assistance
Penn Central Railroad
1970
$676.3 million in loan guarantees –
Gov’t spent $19.7 billion and got back
about $4 billion
Lockheed
1971
Gov’t loan which was paid off
New York City
1975
Loans and loan guarantees
Chrysler
1980
Loan guarantees and warrants – Gov’t
earned a profit of about $660 million
Continental Illinois
1984
Government took 80% ownership and
phrase TBTF was coined
Airline Industry
2001
Gov’t bought stock below mkt and
provided loan guarantees
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 2
Where Did It Come From for Banks?
•
•
FDIAct of 1950 gave FDIC ability to provide financial support through loans or
direct acquisition of assets when the “continued operation of a bank is essential
to provide adequate banking service:
In May 1984 government supported Continental Illinois Bank
–
–
–
–
–
–
•
Discount loans
Credit from a syndicate of lenders put together by then Fed Chairman Paul Volcker
Fed agreed to meet all of Continental’s liquidity needs
FDIC guaranteed 100% of debt
FDIC Provided $2 billion in assistance
Money center banks created an unsecured facility of $5.3 billion at instigation of Fed
Assistance was provided to prevent its failure on several grounds
– Contagion fears
– Fear of disruption to payments and settlement systems
– Effects on correspondent banks
•
•
CofC Todd Conover indicated that government would not let top 11 banks fail
This was birth of TBTF
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 3
Systemic Risk Exemption
• FDICIA 1991
– Instituted Prompt Corrective Action
– Least Cost Resolution – resolve problems at “least possible longterm loss to the deposit insurance fund.”
– Introduced systemic risk exemption- FDIC could violate LCR if it
“would have serious adverse effects on economic conditions or
financial stability; and.... [doing so] would avoid or mitigate such
adverse effects.”
• After FDICIA TBTF morphed into the “systemic risk exemption”
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 4
What Is Systemic Risk?
We Now Know Less Than We Did!
•
What was systemic policy trying to prevent?
– Runs on banks – traditional concern
• Contagion – information asymmetries
– Banking system collapse –
• Continental bank
– Correspondent bank collapse – counterparties
– Jobs would be lost – (St Germain)
– Threat to large dollar settlement system and network effects
– Fear that Infra structure of short term money market and OTC derivatives would not
handle failure of significant counter party and might cast doubts on the soundness of
other counter parties (Bernanke on Bear Stearns)
– Panic due to loss of confidence (Warsh)
– Risks to system due to failure of “highly interconnected” firm
– “Unpredictable consequences of a failure for broader financial system” (Geithner)
– Reaction of counterparties of other firms that might come under future government
control (Kohn on AIG).
– AIG was large, complex and interconnected whose failure would impose losses on
counterparties and also endanger the entire world’s financial sector (BernankeMorehouse Univ, today)
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 5
What Institutions Should Be Considered
Systemically Important and How Do We
Limit the Moral Hazard That It Brings?
•
List of candidates is long and goes far beyond banks to include
– auto companies, cities, airlines, banks and insurance companies.
• But we don’t have a workable definition of “systemically important”
but rather we have an adjective that is used to justify any action that
policy makers deem necessary.
– Without a definition that can be applied ex ante, we have both
uncertainty, and
– An incentive for all large firms to gamble that they too will be included.
• We have little as taxpayers in the way of ex post accountability
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 6
Is Systemic Risk Regulator the Answer?
What would the powers be?
– Closure doesn’t solve the problem
• US can’t grant authority to close an affiliate or subsidiary chartered in
another country
• Because of this how would AIG have been resolved differently?
• Critical issue is dealing with holding companies
• Who would have responsibility?
– Fed
– Treasury
– Shared responsibility
• Should some institution be charged with macro systemic
risk responsibilities?
• How would conflicts be resolved?
– What are the implications for Fed independence?
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 7
Consider 2002-2004
• Fed kept interest rates low as way of getting us out
of recession
– Housing was engine of growth
– People warned about housing bubble
• If Treasury had been systemic risk regulator could it
have forced the Fed to change policy?
• If Fed had been regulator would it have behaved
differently?
• Formal systemic risk responsibility is a losing game
on two accounts
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 8
How to Limit Systemic Risk and TBTF
Subsidies
•
•
Make failures isolated events – if any firm can’t fail and be reorganized then it
should be restructured
Limit excessive leverage
– Focus on capital that would be at risk
• Only two types of liabilities in banks – insured liabilities and liabilities capable of absorbing
losses.
• Abandon risk-based capital concepts
•
•
•
Address consolidated entity issue
Address information asymmetry problems
Address issues of complexity
– Charge complex institutions for the cost of examination and supervision (this is a form
of risk-based insurance premiums)
– Consider restricting derivatives above first degree
– Consider restricting naked swaps
– Put all derivatives on exchanges structure like futures exchanges
•
•
Make unwinding scenario part of examination and supervision
Forget systemic risk regulator concept and just make sure there are no
monetary policy and fiscal imbalances
614 Landis Avenue, Vineland, NJ 08360
800-257-7013
www.cumber.com
Chart 9