The messy killing of too big to fail

Four years after the collapse of Lehman Brothers destabilised the global financial system while highlighting its interconnectedness banking regulators are still trying to develop plans to deal with a similar crisis in future.

Overnight the US Federal Deposit Insurance Corporation and the Bank of England released a paper outlining their agreed approach to dealing with the failure of banks deemed too big to be allowed to fail.

During the aftermath of Lehman's collapse US and UK taxpayers were forced to pump billions of dollars into institutions deemed to be too big to fail – or "global systemically important institutions, or G-Sifis" as they are now called – because of the fear of the consequences if such large, global, complex and opaque organisations were allowed to fail.

Given that so many of the globally important institutions have large operations in both the US and UK – nearly half the G-Sifis – the co-operation plan will provide a template for wider co-operation among international banking regulators with G-Sifis within their jurisdictions.

While all systemically important banks, including the Australian banks, are being required to develop "living wills", or plans for managing their own failure, the approach to G-Sifis broadly has been to impose (at some future date) capital surcharges on them, on top of the extra capital (and liquidity) banks generally are going to be required to hold.

The US and UK plan provides their approach to creating structures and approaches that would allow their regulators to manage the failure of a G-Sifi.

Essentially it is to require there to be a "single point of entry" for the regulators, allowing them to intervene at the holding company level and wipe out shareholders and, to the extent necessary, creditors while being able to forcibly convert remaining debt into equity to recapitalise the institutions without recourse to taxpayers. They'd also fire the senior management.

The idea is to recapitalise the holding companies while allowing sound subsidiaries, whether domestic or foreign, to keep operating to limit contagion and loss of value while the holding company was being restructured and recapitalised. The G-Sifis would have to hold sufficient equity and debt within the top entity to absorb any losses.

The UK has already embarked on its own extra layer of insurance against the collapse of its institutions deemed too big to fail with the Vickers Commission advocating the structural separation of UK banks' traditional domestic retail and commercial banking operations from their global wholesale and investment banking businesses. The ring-fenced domestic businesses would have to hold primary loss-absorbing capital, whether equity or debt that could be forcibly converted, of up to 20 per cent.

The BoE and FDIC plan might appear to deal with the resolution of a failed G-Sifi but in practice it would, like the Vickers Commission recommendations, probably help to avert failure by making equity providers and creditors in particular far more aware of their potential for loss and therefore far more conscious of the need to monitor and understand – and discipline – the risk-taking of their managers than if they believed, as occurred during the crisis, taxpayers would shield them.

The downside from the approaches being taken by the banking regulators is that the extra capital requirements and the higher probability of losses for creditors of G-Sifis in the event of any failure – and the fact that the regulators could simply seize control of the organisation and forcibly convert debt to equity – will be a higher cost of debt and equity for those institutions and therefore either higher costs for their customers and/or less lending.

It could even have the unintended consequence of creating incentives for riskier activities in order to generate higher returns to compensate equity holders for the increased risk and to cover the higher cost of debt.

The regulators, however, ultimately have had no choice but to respond, however tardily, to the glimpse into a financial nightmare provided by the crisis and try to create some approach to dealing with institutions deemed too big to fail and the cross-border contagion issues implicit in that status.

The other layer of protection, of course – as Canada and Australia demonstrated during the crisis – is better hands-on prudential regulation and a real understanding of the risks the institutions are actually exposing themselves and their taxpayers to.