Bankruptcy Is Not an Option

The scenario of American big banks “running into trouble” offers only bad solutions. It is clear, following the Lehman Brothers bankruptcy and its aftermath, that bankruptcy is not a viable option for large and complex financial institution.

The legal process that bankruptcy entails is disruptive, costly, and inefficient, and this can have potentially severe spillovers throughout the financial system and beyond. There is little hope that the issues associated with harmonization of processes in different jurisdictions will be resolved any time soon. For now we must face up to this reality: large U.S. banks will not be allowed to go bankrupt.

A crisis situation occurs even before any bank is known to be insolvent. The mere suspicion that a bank might be in trouble prevents its debt from being renewed and can lead to massive fire-sales, instability, credit disruption and possible contagion.

To stabilize the system, governments often feel compelled to offer guarantees or, if necessary, to bail out a failing institution. While we hate bailouts, we swallow hard and offer them. Politicians are fond of trying to commit to “no more bailouts,” but these statements are not credible and they should not be made. Bailout might simply turn out to be the best option in a crisis.

Bailouts are not only extremely costly, but the knowledge that they will be forthcoming creates severe distortions. Banks can borrow at rates that do not reflect the riskiness of their investment, and from creditors who do not care to monitor what the banks do with the money. This leads banks to borrow too much and to take on too much risk, which in turn further increases the fragility of the system and the likelihood of crises and bailouts.

Even worse, with the heavy burden of prior debt commitments, highly leveraged banks have trouble funding additional, even valuable, investment. This was evidenced in the credit freeze during the crisis and it continues to affect the ability of banks to be as useful to economy as they can.

The situation is unacceptable and we must address the dramatic growth of banks. “Too big to fail” banks are likely already too big. If we can figure out how to handle this in a way that would reduce systemic risk, breaking banks to smaller entities would be helpful.

Whatever we do regarding the size of banks, and even if banks are smaller, the solution should attack the main culprit in the fragility of banks: their excessive leverage.

There is no reason for us to allow banks to be anywhere near as highly leveraged as they are, or even as high as the new Basel III international capital standards accord would allow.

Basel III has failed mainly because it continues to allow banks to remain excessively and dangerously leveraged. Society would benefit if banks had 30 percent or even more equity financing. Switzerland already has higher requirements. Mervyn King of the Bank of England has recently set out the case for higher requirements. With a lot more equity, banks own up to the risks they take, and back up more of their liabilities, making the system significantly safer and healthier.

Proposals such as requiring banks to write living wills, devising “bail-in” scenarios, or contingent capital are complicated and, realistically, cannot be expected to work to prevent a crisis. They offer no advantage over requiring a lot more equity. And the arguments made by leading bankers against higher equity requirements are completely misleading.