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June 4, 2010 Friday 3:13 PM EST
SECTION: NEWS & COMMENTARY; Economy and Politics; Capitol Report
LENGTH: 1557 words
HEADLINE: Do bank bills prepare for next financial collapse?
BYLINE: Ronald D. Orol, MarketWatch mailto:email@example.com.
Ronald D. Orol is a MarketWatch reporter, based in Washington.
WASHINGTON (MarketWatch) — The Senate has approved the most significant expansion of the regulations governing U.S. financial firms since the Great Depression, yet as the rules inch closer to becoming law, legislative observers worry that the major changes won’t be enough to ward off a future economic crisis.
“Big banks will have every advantage in the credit market to get bigger and riskier if this bill passes, and we won’t have solved ‘too big to fail,” said Simon Johnson, Massachusetts Institute of Technology Sloan School of Management professor and former International Monetary Fund economic counselor. “In many ways, you’ve moved a huge step closer to becoming Greece.”
Johnson argues that the only real way to limit future crises is to break up the big banks so no bank failure can cause collateral damage to the markets.
Instead, the more than 1,600-page legislative package — which passed the Senate with the backing of four Republicans — includes new varied costs and stronger capital limits on big banks, tough new rules for credit-rating agencies and a one-time audit of the Federal Reserve.
It permits bank regulators to break up big banks but does not require them to do so, as Johnson and others are advocating, and it seeks to impose new record-keeping, reporting and capital requirements onto a huge swath of the opaque $450 trillion derivatives market.
The Senate legislation would have to be reconciled with a bill approved by the House that contains many similar and different provisions. Top members of both chambers are scheduled to begin negotiating their bills on Wednesday, with a goal of having a final bill on the president’s desk for his signature before July 4.
Specifically, the Senate legislation seeks to avoid a repeat of the drawn-out and disorderly bankruptcy process for Lehman Brothers Holdings Inc. (LEHMQ) last September that led to a cascade of defaults that shook financial markets and rippled through the global economy.
It would set up a mechanism to dismantle a failing big bank that’s determined to be so big or so interconnected that if it collapsed suddenly it would threaten the economy’s stability. In the event of a impending implosion, the legislation would use taxpayer dollars to make partial payments to “healthy” creditors and counterparties of a failing megafirm so that they wouldn’t go down with it. Once economic disaster is averted, the bill would seek to recoup the costs from big banks.
With one provision, regulators could borrow $1.8 trillion from taxpayers to fund the resolution of an institution with $2 trillion in assets.
MIT’s Johnson said he believes that in the event of another economic implosion, the U.S. resolution authority wouldn’t do enough to limit the crisis caused by a failing big bank, in part because the megafirms likely to cause future crises are global in nature.
Countries wouldn’t come to agreement on how to divide up the costs of a failing big bank, according to Johnson, which like Lehman Brothers will likely have thousands of contracts traversing over a dozen national borders. “When a big bank fails, countries will not agree to a cross-border resolution authority,” he added. “You would still end up with the haphazard approach we had in this crisis.”
Christopher Whalen, managing director of Institutional Risk Analytics, in Torrance, Calif., said that — like in the crisis that shook the economy in September 2008 — it would be difficult for bank regulators to differentiate between the healthy and failing institutions.
“At a given point in time they are all insolvent,” he commented.
Another problem: Unlike the House bill, the Federal Deposit Insurance Corp. would be prohibited from guaranteeing the debt of solvent institutions during a crisis until it receives prior approval from Congress, a hurdle the Obama administration is furiously working to remove.
Brookings Institution analyst Douglas Elliott agreed the restriction would make it more difficult to rein in a growing crisis at a critical time. “You could have a severe enough crisis where we really should be bailing out some firms to save the economy. What you may end up having is the chaotic kind of approach that we just experienced,” Elliott remarked.
Whalen warns the House provision raises all sorts of problems, leaving taxpayers more exposed, not less. He said the FDIC’s handling of the September 2008 crisis with guarantees is a classic example of a government regulator handling an economic emergency in a way that did not cost taxpayers money.
That ability would be eliminated if Congress rejects the guarantees, he said. “It would be a mess. You would assure that the FDIC would have to ask Treasury for taxpayer funds.”
Richard Bove, vice president at Rochdale Research, argues that a systemic-risk regulator in the bill — chaired by the Treasury and charged with monitoring and responding to systemic risks posed by large complex banks — is a superstructure that is unworkable.
“The Treasury is going to review hundreds of thousands of transactions to make sure they don’t go bad and pass that information to this systemic-risk council,” he said.
Johnson contends that both Senate and House end-user exemptions to new transparency regulations on derivatives are really huge loopholes that allow financial institutions to take risk off their balance sheets, so regulators and the broader market won’t have the full picture of each institution’s risk to the financial system.
Lisa Lindsley , director of capital strategies at the American Federation of State, County and Municipal Employees in Washington, said that the Senate bill, as it stands, leaves America vulnerable to another near-disaster akin to American International Group Inc. (AIG)
Proponents of the new oversight have blamed credit-default swaps — a controversial derivative product sold by AIG — as central to the financial crisis, in part because the interconnected nature of CDS securities required regulators to inject the institution with a $190 billion taxpayer bailout or face an even more expansive crisis.
Seeking to prevent another AIG, both the Senate and House bills seek to require a large part of the opaque derivatives market to trade through clearinghouses, or intermediaries between buyers and sellers, and on exchanges. However, a Senate provision allows clearinghouses to reject contracts that securities regulators have deemed must be cleared.
“Banks can argue that they don’t need to clear a trade because a clearinghouse has said they don’t want to clear it,” according to Lindsley. “The fewer derivatives that trade through a clearinghouse, the less regulators and the broader market will know about the market, and that’s dangerous.”
The Senate bill would be the most desired bill, she said, if this and two other provisions that help banks avoid clearinghouses and exchanges are removed. That’s because the House bill allows a larger segment of derivatives users to be exempted from clearinghouses.
Institutional Risk Analytics’ Whalen asserted it is critical for as much as possible to trade through clearinghouses and on exchanges. “Once you move the vast volume of derivatives onto exchanges, you don’t have a systemic-risk issue because there is a separate entity that holds collateral.”
Another worry is a provision in the Senate bill that allows clearinghouses to have normal access to the Federal Reserve’s discount window — a government-lending facility through which commercial banks borrow reserves.
Gary Gensler, chairman of the Commodity Futures Trading Commission, has argued that clearinghouses only should have emergency access to the discount window. But AFSCME’s Lindsley said that the access could discourage clearinghouses from being sufficiently capitalized: “We don’t want clearinghouses to be too big or interconnected to fail.”
Volcker rule and more
Much has still to be worked out. The so-called Volcker rule — named after ex-Federal Reserve chief Paul Volcker, who chairs President Barack Obama’s economic advisory panel — would bar big commercial banks from making speculative derivatives and stock investments for their own accounts.
The measure, in its full form, is not in the bills. It would also cap the size of big banks and force financial institutions to divest hedge funds and private-equity units. So far, the House bill only permits regulators to impose these restrictions at their own volition. The Senate bill is slightly tougher and requires bank regulators to conduct a study on the Volcker rule and follow its recommendations.
Nevertheless, the measure could make a comeback. Tara Andringa, spokeswoman for Sen. Carl Levin, acknowledged that a Volcker-rule provision introduced by the Michigan Democrat could still be in play. One possible scenario: Bring it in to replace another controversial measure in the bill that requires big banks to spin off swaps desks into well-capitalized affiliates.
Another tough provision regards the response to federal and state investigations into conflicts of interest at financial institutions and credit-rating agencies. The Senate bill has a controversial measure to create a clearinghouse intermediary to assign credit raters for banks’ structured-finance securities.
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