Bailouts forever
Regulators say too-big-to-fail is over. Markets don't believe them - and recent history shows why.
The 2010 Dodd-Frank Act in the United States promised the end of bank bailouts and “too-big-to-fail” institutions. The European Union’s 2014 legislation for dealing with banks likely to fail was claimed to provide “a framework” to “deal with banks that experience financial difficulties without either using taxpayer money or endangering financial stability.” In November 2014, Mark Carney, at the time the governor of the Bank of England and chair of the Financial Stability Board (FSB), a body of financial regulators from around the world, announced triumphantly that an agreement about new rules for the thirty largest and most complex, “globally systemic” financial institutions would prevent bailouts in the future. Many people in politics and the media believed these claims.
In a similar vein, Finma, the Swiss bank supervisor, announces on its website: “Financial market participants can become so large at a national and even international level that their disorderly failure could undermine financial stability and force a government bail-out. Following the global financial crisis of 2007 and 2008, the 'too big to fail' problem was therefore addressed both in Switzerland and abroad.” Notice the factual claim: “the problem was addressed.”
The confidence expressed in these statements stands in marked contrast to the actual events in March 2023. When faced with a run on Credit Suisse, one of those thirty “globally systemic” institutions, the Swiss authorities, including Finma, did not actually use the new procedures that had been developed to deal with banks that are in trouble. Instead they engineered a bailout. The bailout announced on March 19, 2023, took the form of a takeover by larger rival UBS, with liquidity support from the Swiss National Bank guaranteed by the government for up to 100 billion Swiss francs and with a government guarantee of up to 9 billion Swiss francs against certain losses.
So much for the promise that bailouts are a thing of the past! Karin Keller-Sutter, the Swiss finance minister who was responsible for this plan, said at the time that a "globally active systemically important bank cannot simply be wound up according to the 'too-big-to-fail' plan. Legally this would be possible. In practice, however, the economic damage would be considerable.” The Swiss finance minister and the head of the supervisory authority also explained that the new procedures could not be used because CS had lost all trust with investors.
One may wonder why the regulators designed rules for dealing with failing banks without considering the possibility that such a bank would lose the investors’ trust. If a bank is highly distressed, it is natural for investors to doubt whether it is solvent and for trust to disappear. Any rules for dealing with failing banks should be designed to work even in that plausible scenario. If the regulators did not imagine such a scenario, the question is why they were so naïve.
Financial markets have long shown skepticism about the effectiveness of new rules and procedures intended to end bailouts. Empirical research has shown that globally systemic institutions are still able to fund their investments at lower costs than other institutions taking similar risks. This funding advantage reflects investors’ expectations that these institutions are still too important to fail and will receive government support should they run into problems or in a crisis. We share the skepticism about the end of too-big-to-fail. Long before the Credit Suisse weekend, we wrote that government support and bailouts were still to be expected if an important institution were to fail. Therefore, we were not surprised that the Swiss authorities proceeded as they did.
In the remainder of this essay, we discuss the rule changes that were introduced since 2010 and their shortcomings. The major problem is that no matter what they may say in public, most politicians prefer bailouts to anything else. They hate to impose losses on anyone, particularly on people whose votes (or financial support for campaigns) they want to have in the next election. They also shy away from the difficulties and intricacies of dealing with actual bank operations. Finally, they continue to fear the collateral damage caused by failing banks.
Ending too-big-to-fail—A pipe dream
The optimism expressed by Governor Carney in late 2014 rested on two innovations, but these innovations will not fulfill the hopes attached to them. The first innovation is called Single-Point-of-Entry (SPE) resolution, the second is called Total Loss Absorbing Capacity (TLAC). The term “resolution” is short for “bank resolution,” used for procedures by which authorities intervene to “resolve” the problems of failing banks without subjecting the banks to a bankruptcy procedure. In a SPE resolution, one authority takes control at exactly one point, usually the headquarters of the overall group. Most large banking institutions are organized as bank holding companies whose subsidiaries carry out the actual business operations. In an SPE resolution, the authorities enter the bank holding company but not the subsidiaries.
In theory, SPE resolution has two advantages: First, the authorities do not have to interfere with the actual operations. Operations take place in the subsidiaries, which the authorities do not enter. Second, for banks with subsidiaries in multiple jurisdictions, SPE resolution eliminates the problem of what happens when the subsidiaries in different jurisdictions are entered by different authorities, namely one for each jurisdiction in which the bank has a legally independent subsidiary. Because of these advantages, the Financial Stability Board has repeatedly urged for the authorities of different countries to agree on SPE resolution.
Both supposed advantages are illusory, however. First, the idea that a resolution authority need not concern itself with the subsidiaries and their operations presumes that all relevant information is easily available at the level of the bank holding company. In particular, it presumes that there is no need to interfere with ongoing operations or even to wind some operations down. Second, the idea that different countries and jurisdictions will allow the resolution authority in charge of the bank holding company to decide on the fate of subsidiaries in their territories is unrealistic. U.S. authorities have made clear that they will not submit to interventions of foreign banks’ home country authorities using SPE procedures that might impose losses on the clients of these banks’ subsidiaries in the United States. Instead, they have required large foreign banks to organize their U.S. operations under bank holding companies in the United States, and they intend to apply “SPE” resolution to these holding companies and their subsidiaries. True SPE resolution of the overall organization, in the home country and in the United States, is thereby impossible. U.S. authorities thus avoid submitting to the organization’s home country authorities.
The other innovation, Total Loss Absorbing Capacity (TLAC), is not an innovation at all but a marketing trick. The idea is that banks should maintain a minimum amount of funding that can absorb losses in bank resolution. Equity has this ability automatically. In addition to equity, however, the holders of some debt securities might have no claim to be bailed out. Together with equity, these securities would provide TLAC. Whereas equity would absorb losses at any time, “loss-absorbing debt” would absorb losses in a resolution or bankruptcy procedure. The slogan was “Equity before bankruptcy, TLAC in bankruptcy!”
The exemption of insured deposits and several other liabilities from sharing a bank’s losses is a privilege, but the presentation of “loss absorbing debt” treats it as a rule.
The presentation of debt that can absorb losses as something special is a rhetorical sleight of hand. Outside of banking, there is a general presumption that lenders must absorb losses if the borrower defaults and goes into bankruptcy. Because of the disruptions associated with standard bankruptcy procedures, alternative and more flexible resolution procedures have been created for banks. However, this change is not a reason for deviating from the general principle that uninsured creditors must share in losses according to the seniority of their claims if the bank fails. The exemption of insured deposits and several other liabilities from sharing a bank’s losses is a privilege. The TLAC discussion suggests that politicians and bankers see this privilege as the rule, and debt that must share losses in resolution or bankruptcy as the exception.
The mantra “Equity before bankruptcy, TLAC in bankruptcy” suggests falsely that equity and “loss-absorbing debt” serve different needs and that one is not a substitute for the other. In fact, equity and loss-absorbing debt are different ways to fund the banks’ activities, and funding by equity instead of loss-absorbing debt will avoid the need to go into bank resolution in the first place, so loss absorption by debt becomes much less relevant. Equity absorbs losses automatically and prevents a corporation from becoming distressed or failing. Debt absorbs losses only when the trigger for a bankruptcy or resolution procedure is pushed.
To be sure, once a resolution is triggered, loss absorption by debt may reduce the need for taxpayer money. In some circumstances, loss absorption by debt may even eliminate the need for taxpayer money altogether. Whenever TLAC debt absorbs all losses, however, the need for triggering a bankruptcy or resolution procedure would not even have arisen had the same funding taken the form of equity. This greater equity funding would prevent the bank from failing in the first place.
The trigger for a bankruptcy or resolution procedure is only pushed if governments and regulators are confident that they will not cause harm to themselves and their friends or to the financial system. If the authorities have reasons to avoid triggering a bankruptcy or resolution procedure, it makes no difference that some debt securities are available for absorbing losses in such a procedure. In the case of Credit Suisse, the authorities preferred to have the bank taken over by UBS with much public support even though, in addition to equity and the contingent-convertible debt that was devalued, the bank also had about 50 billion Swiss francs’ worth of TLAC debt, so loss absorption by TLAC liabilities should have been easy.
Before the financial crisis of 2007–2009, banks had issued a variety of debt securities that, under the then-prevailing rules, counted toward capital requirements as “Tier 2 Capital,” available for immediate loss absorption in bank resolution. In the crisis of 2007–2009, however, these securities did not contribute to the absorption of losses because governments preferred to bail out the banks and all their creditors for fear of the possible contagion effects of triggering a bankruptcy or resolution procedure. We expect the same choices to be made again if there is another systemic bank failure or crisis.
Excerpted from The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It - New and Expanded Edition © 2024 by Anat Admati and Martin Hellwig. Reprinted by permission of Princeton University Press.
Anat R. Admati is the George G.C. Parker Professor of Finance and Economics at Stanford Graduate School of Business, a senior fellow at Stanford Institute for Economic Policy Research, and a Niskanen Center advisory board member.
Martin Hellwig is director emeritus at the Max Planck Institute for Research on Collective Goods in Bonn.
Read more:
Can democracy take stock of Wall Street? (Editor’s note)
Capital confusion - by Anat Admati and Martin Hellwig
The myths that fuel the megabanks - by Thomas Hoenig
Giving power to truth - by Colleen P. Eren
It's time to challenge Wall Street from the supply side - by David Dagan
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