Rescuing the Banks is More Complicated Than Last Time

We should take notice of a joint article by Ben Bernanke, Tim Geithner and Hank Paulson last week in the New York Times iii. It was effectively an admission that there will be another financial crisis, and as such, these three men who presided over the last one must be worried that we are now heading towards the next.

They point out that some of the tools they deployed ten years ago are no longer available. The critical paragraph is the following:

But in its post-crisis reforms, Congress also took away some of the most powerful tools used by the FDIC, the Fed and the Treasury. Among these changes, the FDIC can no longer issue blanket guarantees of bank debt as it did in the crisis, the Fed’s emergency lending powers have been constrained, and the Treasury would not be able to repeat its guarantee of the money market funds. These powers were critical in stopping the 2008 panic.

Their concern is that under current legislation and regulations, a similar crisis to Lehman would increase the risk of a total collapse of the financial system, because the financial authorities have their hands tied. While there is some truth in their concerns, they might be overcome by emergency executive orders from the president.

The authors are oddly silent on the larger problem that makes a globally coordinated financial and systemic rescue much more difficult, and that is the bail-in provisions adopted by all the G20 members and enshrined in their laws. Last time, bail-outs and nationalisation of the banks were the methods deployed, and they protected both depositors and bond holders. The cost was borne entirely by the state.

Without much thought, bail-in provisions were introduced specifically to prevent the cost of future bank failures being forced on the state, and instead the costs are to be shared by bond holders and uninsured depositors. Their application to individual failures of banks not deemed systemically important financial institutions is actually superfluous, because normal bankruptcy laws are sufficient for these instances. The difficulty occurs when a potential bank failure threatens to escalate into a systemic threat. But if you bail in such a bank, by forcing losses upon bond holders and uninsured depositors, you simply escalate a systemic problem.

The three men at the center of the Lehman crisis appear to have learned little from their experience. The overriding lesson is of the futility of closing some stable doors while opening others.

- Source, Alasdair Macleod via James Turk's Goldmoney