Baseline Scenario

The Baseline Scenario
This Is Their Reform Strategy For Big Banks?
Posted: 02 Jul 2009 02:32 AM PDT
Anil Kashyap is one of our leading researchers on banks. His book with Takeo Hoshi on the evolution of the Japanese corporate finance is a must read on the twists and turns that built a great economy and then laid it low. And he has many other papers and relevant recent commentary.
Professor Kashyap has a sharp perspective the administration’s financial sector reform thinking, in part because he has long worked alongside key people now at the National Economic Council (the NEC, by the way, has disappointingly little transparency; even Treasury is more open).
So we should take him seriously, writing Tuesday in the Financial Times, on the importance of the proposed new “funeral plans” for banks.
Kashyap’s point is that if banks are forced to explain, in convincing detail, how they can be wound down, this will effectively limit the complexity and scale of their operations. (See “Rapid Resolution Plans” on p.25 of the regulatory reform proposals; p.26 in the online NYT version)
The notion is intriguing, if such rules are actually enforced. Essentially, banks would be required to specify the extent and nature of costs for any bailout they may require.
A key part of any plan would be the people involved. Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)? Would they therefore require large retention bonuses? How large exactly?
You can see how such resolution planning might go wrong – particularly if banks were only forced to consider whatever they now regard as “normal” risks. Remember the head of quantitative equity strategies who said, in early August 2007, “Events that models only predicted would happen once in 10,000 years happened every day for three days.”
A checklist approach is definitely not going to work (been there, done that, for countries). You need something that can simulated or, even better, played out in a war game. Bring in some difficult outsiders and try to break the bank in the messiest way possible (in a game), then follow the consequences and costs.
These banks are so large and intertwined with so many other, it’s hard to fathom how a “funeral plan” would be reassuring – unless it means that they become smaller and less complex.
And this brings up the real weakness of this approach to reform – the political economy. How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup or JP Morgan Chase? The CEOs of those firms have direct access to the Secretary of the Treasury and on Pennsylvannia avenue they are regarded as gurus and bastions of the economy. They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.” Which recent Treasury Secretary would be able, at that moment, to face them down – particularly as these bankers can, if pushed, go to the big boss?
On top of this, keep in mind there is no cross-border resolution authority currently on the table in the US regulatory reform proposals or at the G20 level. The Europeans say they are inching in this direction; I’ll believe that when I see it. In our next boom-bust iteration, big banks may well be regarded as having ”too many cross-border liabilities to fail”, so there’ll be another quasi-bailout with potentially huge fiscal costs.
And then someone will promise a new regulatory reform plan.
By Simon Johnson