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WASHINGTON:Truth from the Top

WASHINGTON, DC – It is unusual for a senior government official to produce a short,
clear analytical paper. It is even rarer when the official’s argument both cuts to
the core of the issue and amounts to a devastating critique of the existing order.

In a speech delivered on February 24, Thomas M. Hoenig, Vice Chairman of America’s
Federal Deposit Insurance Corporation (FDIC), did exactly that. These four pages are
a must-read not only for economic policymakers around the world, but also for anyone
who cares about where the global financial system is heading.

Hoenig, former President of the Federal Reserve Bank of Kansas City, has spent his
career working on issues related to financial regulation. He communicates
effectively to a broad audience – and understanding the technicalities of finance is
not needed to grasp his main points.

One of those points is that the world’s largest financial firms have equity that is
worth only about 4% of their total assets. As shareholders’ equity is the only real
buffer against losses in these corporations, this means that a 4% decline in their
assets’ value would completely wipe out their shareholders – taking the companies to
the brink of insolvency.

In other words, this is a fragile system. Worse, the current regulatory treatment of
derivatives and of funding for large complex financial institutions – the global
megabanks – exacerbates this fragility. Perhaps we are moving in the right direction
– that is, toward greater stability – but Hoenig is skeptical about the pace of
progress.

As he points out, the relevant studies show that the megabanks receive large
implicit government subsidies, and this encourages them to stay big – and to take on
a lot of risk. In principle, such subsidies are supposed to be phased out through
measures being taken as a result of the 2010 Dodd-Frank financial-reform
legislation. In practice, these subsidies – and the politics that makes them
possible – are firmly entrenched.

The facts may startle you. In 1984, the US had a relatively stable financial system
in which small, medium, and – in that day – what were considered large banks had
roughly equal shares in US financial assets. (See Hoenig’s chart for precise
definitions.) Since the mid-1980’s, big banks’ share in credit allocation has
increased dramatically – and what it means to be “big” has changed, so that the
largest banks are much bigger relative to the size of the economy (measured, for
example, by annual GDP). As Hoenig says, “If even one of the largest five banks were
to fail, it would devastate markets and the economy.”

The Dodd-Frank legislation specifies that all banks – of any size – should be able
to go bankrupt without causing massive disruption. If the authorities – specifically
the Federal Reserve and the FDIC – determine that this is not possible, they have
the legal power to force the banks to change how they operate, including by reducing
their scale and scope.

But the current reality is that no megabank could go bankrupt without causing
another “Lehman moment” – that is, the kind of global panic that resulted in the
days after Lehman Brothers failed in September 2008.

In particular, experts like Hoenig who have thought about the cross-border
dimensions of bankruptcy emphasize that it simply would not work for a corporation
the size of JPMorgan Chase ($3.7 trillion in assets), Bank of America ($3 trillion),
or Citigroup ($2.7 trillion).

“Panic is about panic,” Hoenig says, “and people and nations generally protect
themselves and their wealth ahead of others. Moreover, there are no international
bankruptcy laws to govern such matters and prevent the grabbing of assets.” I would
add that the chance of bankruptcy courts cooperating across borders in this context
is nil.

As a result, the Federal Reserve and the FDIC should move immediately to force the
megabanks to become much simpler legal entities. Current corporate structures are
opaque, with the risks hidden around the world – and various shell games allowing
companies to claim the same equity in more than one country.

Breaking down the components of banks into manageable pieces makes sense. The
Federal Reserve has recently taken a step in that direction by requiring that global
banks with a significant presence in the US operate there through a holding company
that is well-capitalized by US standards.

This is not about preventing the flow of capital around the world. It is about
making the financial system safer. Anyone who disputes the need to do this – and
much more – should read and respond to Hoenig.

Simon Johnson is a member of the FDIC’s systemic resolution advisory committee,
an unpaid position. The views expressed here are his alone.

Project Syndicate

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