Bloomberg this morning included an article on recent comments by Fed Governor Daniel Tarullo on a push by regulators to require banks to fund themselves more appropriately:
Federal Reserve Governor Daniel Tarullo is pushing an agenda to regulate banks beyond the restraints in the Dodd-Frank Act, including making them fund more of their assets using long-term borrowing.
The Fed and the Federal Deposit Insurance Corp. are holding preliminary discussions on a rule that would require holding companies for the largest U.S. banks to maintain a minimum amount of long-term debt that would aid in winding them down in case they fail, FDIC spokesman Andrew Gray said.
Mr. Tarullo explained the general dynamics of this shift in a speech in December at a Brookings Institution conference:
The basic idea is that the maintenance of minimum levels of long-term debt at the top holding company level will allow a resolving authority to transfer operating subsidiaries of the failed firm to a functioning bridge entity, while leaving behind in a receivership the equity and sufficient long-term debt to absorb the original firm’s losses. Eventually, the resolving authority could recapitalize the bridge entity by exchanging claims of the long-term unsecured creditors of the parent for equity, long-term debt of the bridge, or both.
In plain English, Tarullo is saying that requiring banks to fund themselves with a threshold level of long-term bonds would give regulators room to re-engineer the banks’ capital in the event of another crisis. Restructurings impose significant short-term losses on the holders of those bonds. Exposing bondholders to this risk would give them the “skin in the game” that regulators like to talk about so much, and would in theory give banks an incentive to control their own risks better.
But that incentive only makes sense if there are risks attached. Put another way, there can’t be “market discipline” without the stick of penalties. And the Fed itself has shown that it is almost pathologically unwilling to allow bank bondholders to incur losses. This is a point that fund manager John Hussman has been making since early 2008, when he wrote the following after Timothy Geithner (then president of the NY Fed) testified to the Senate Banking Committee about the end of Bear Stearns:
Among thosewas a question by the Committee to the effect that while it was clear that Bear Stearns’ shareholders had not been “bailed out,” the same could not be said for Bear Stearns’ bondholders – didn’t this send a signal to the credit markets that could encourage excessive risk taking in the belief that the government stood behind the bonds of private companies? Geithner gave a general response that credit spreads among financial companies remained relatively wide, so the market had not been provided with that sort of confidence. There was no follow-up question.
Hussman later expanded on this point with some data on just how much losses could have been absorbed by a failing Lehman Brothers if the Fed had not stepped in to protect the bond holders:
In Lehman’s case, $20 billion in shareholder equity is a very thin pool of funds to eat through when you’re not confident in the true market value of the $600 billion in assets held by the company. But it’s crucial to recognize that if you include both shareholder equity as well as Lehman’s debt (bonds and subordinated debt), you’ve got a $143 billion cushion to eat through before any customer or counterparty would be at risk. With that kind of cushion, the issue is not, and probably will never be whether customers or counterparties are at risk. The only issue is whether you save the bondholders.
Indeed, although Tarullo’s quote in the Bloomberg piece implies that banks need to issue more long-term debt, the reality is that they have already done so. As Hussman noted in 2011:
The amount of bondholders and equity coverage [among large financial institutions] varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions.
Tarullo echoed this point in his December speech, when he described it as “notable that, at present, large U.S. firms have substantial amounts of long-term debt on their balance sheets.”
With that in mind, I have two questions for Mr. Tarullo:
- If the banks already have “substantial” levels that (per Mr. Hussman) are “more than sufficient to absorb any losses,” then how would a rule requiring them to do what they are already doing help?
- How can we be sure that the rule will be meaningful if the implicit promise of the government to step in and fund these banks remains in force?
Tarullo’s remit within the Federal Reserve system is one of its most important – defining, measuring and controlling systemic risk. It’s hard to have much confidence that his work will be meaningful as long as the Fed and the Treasury reserve the right to prop up banks at their own discretion.