Skip to content

Fed Conference in Hotlanta – Turning up the Heat on Too Big to Fail

robin anderson

Last week I had the opportunity to attend the Atlanta Federal Reserve‘s Financial Markets Conference, titled Maintaining Financial Stability: Holding a Tiger by the Tail. This year’s topic – as the pun in the title suggests – was the regulation of financial firms to manage tail-risk events. Tail-risk events are those that have a statistically low probability of happening, but a large potential cost if they do. They’re called tail-risk events because in a standard normal distribution curve that has a peak in the middle and sloping tails out to both sides, these are the events that take place out in those tails.

Tail-risk events associated with the financial system negatively affect a country’s financial system, and a stable, developed financial system is a key condition for economic growth. Banks and other financial intermediaries exist to move money from households and businesses that have extra (savers) to those who need more (borrowers).  An efficient financial system reduces transaction costs and information costs (such as moral hazard and adverse selection), making it cheaper for firms and households to access credit.

The Pitfalls of Risk Management

One theme of the conference was a focus on a particular source of potential tail-risk: “too big to fail” institutions. The discussion was on progress in regulators’ ability to unwind these large interconnected financial institutions (a.k.a. systemically important financial institutions, or SIFIs) if one or more of them fail. The good news is that progress has been made. Under the Dodd-Frank Act, SIFIs now have to have “living wills,” plans showing how they may be unwound under bankruptcy code.  Had such things existed when Lehman Brothers failed, regulators’ jobs to unwind the firm certainly would have been much easier.

Speaking of which, Lehman isn’t actually dead, and won’t die until after 2017. Lehman will ultimately pay back about 18%, on average, of what it owed creditors (though, reports just out suggest that creditors of Lehman’s European arm may get all of their money back). According to the FDIC, with the new powers they have under Dodd-Frank Title II, they could have given Lehman’s creditors back an average of 97% of the money owed.  If a SIFI could legally and efficiently be unwound, that could eliminate the need for bail outs.  A clear path to bankruptcy would help reduce the risk of moral hazard; it would reduce the incentive for SIFIs to take on too much risk because they would no long think they’d ultimately be bailed out by the government.

Economist John Taylor and lawyer Ken Scott proposed the creation of a special judicial bankruptcy code for financial institutions – Chapter 14.  This proposed code could supplement and improve up the Title II powers endowed to the FDIC by reducing bureaucratic discretion and improving clarity in policy. But the real question is how do you get judges and creditors to agree on who gets their money back and who doesn’t?

In addition, regardless of whether you use judicial bankruptcy or the Title II powers bestowed to FDIC, it’s a reach, at best, to reasonably assume that global regulators would want to work within the boundaries of U.S. law to unwind a global company. For example, Lehman had about 2,000 companies globally. As the New York Times put it (quoting the FDIC’s own Lehman report), the only way that the FDIC could hope to deal with the global nature of a SIFI such as Lehman is, “The FDIC would have contacted the relevant foreign and domestic regulatory authorities and governments to coordinate the resolution.” Sounds simple, but contact the relevant authorities for 2,000 global companies? Really?

The ideal solution to the challenge of resolving a global financial institution would perhaps be the harmonization of bankruptcy laws as John Taylor and his colleague Ken Scott suggested.  However, that is a long way in the future, and at this point may be more applicable to sci-fi than SIFI.

You can check out more of my thoughts on the Atlanta Fed conference in our Weekly Economic Insights, as well as views on China’s economy and Europe’s struggling recovery.

The information in this article has been derived from sources believed to be accurate.  Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

The information in this article contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation, nor should it be relied upon in any way as a forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

Subject to any contrary provisions of applicable law, no company in the Principal Financial Group nor any of their employees or directors gives any warranty of reliability or accuracy nor accepts any responsibility arising in any other way (including by reason of negligence) for errors or omissions in this article.

The Principal may provide, or third parties may provide, for your convenience and information only, links to other World Wide websites. Because The Principal does not have control over these sites, you agree that The Principal is not responsible for any liability resulting from the access or use of sites not owned by The Principal and that The Principal is not responsible for any content, advertising, product, or any other matter or issue, available through the World Wide Web, whether linked to, or from, websites of The Principal. Further, you agree that The Principal shall not be responsible or liable, directly or indirectly, for any damage or loss caused, or alleged to be caused by or in connection with the use of websites The Principal does not own

Principal Global Investors is the asset management arm of the Principal Financial Group ® (The Principal ®)1

1“The Principal Financial Group” and “The Principal” are registered trademarks of Principal Financial Services, Inc., a member of the Principal Financial Group.

Leave a Comment

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: