In part one, the appetizer, we quickly looked at whether the US banking sector is stronger than it was in 2008, as Lewis Alexander, the new Nomura chief US economist, argues. On the face of it, he’s right — balance sheets appear stronger, but we can’t be sure.
In part two, the main course, we look at what would happen if a crisis was to hit again.
The challenge for policymakers
Alexander’s note is an extremely useful account of policymakers’ toolkit roughly 17 months since the passage of Dodd-Frank.
Although Alexander finds their capabilities weakened, it’s worth noting that this is as much feature as bug. Dodd-Frank was intended to discourage future bailouts. And one consequence is that it incentivises both banks and policymakers to act earlier in defending against them – banks because they know that help will be less forthcoming, and policymakers because they know the limits of their emergency powers.
Alexander explains how the legal authority for the many policy initiatives that were used to stabilise the financial system from 2007-2009 relied to some degree on three things:
– the Troubled Asset Relief Program (TARP)
– the Federal Reserve’s emergency lending authority under Section 13(3) of the Federal Reserve Act
– the FDIC’s authority to provide support to individual banks and to take other actions to mitigate ‘systemic risk’
You can get a depiction of the intersection between these three items and the various measures taken by clicking to expand this chart…
… and the CliffsNotes version of the actual changes here:
Let’s take a look at each of the three key powers in turn.
1) Tarp expired, and any new version is unlikely to have either as much firepower or as free a mandate.
Tarp was necessary but far from ideal. Given the risk borne by taxpayers, its implementation left them with far too little of the upside once banks recovered — and understandably, the public continues to interpret it mostly as a banker bailout (which it was) rather than something needed to prevent a financial and economic catastrophe (which it also was).
And combined with the political environment we find ourselves in, it’s unlikely that the government would be able to quickly approve something similar now.
This was all anticipated by the Congressional Oversight Panel in its report on Tarp in September 2010:
The TARP’s unpopularity may mean that, unless the program’s effectiveness can be convincingly demonstrated, the government will not authorize similar policy responses in the future. Thus, the greatest consequence of the TARP may be that the government has lost some of its ability to respond to financial crises.
This is what has happened, and it’s become relevant earlier than we’d imagined it would.
2) The Fed’s emergency lending authority has been changed.
Here’s the germane part from Alexander’s note:
The Federal Reserve’s 13(3) authority to extend credit broadly under “unusual and exigent” circumstances was changed under Dodd-Frank. The critical phrase that gave the Federal Reserve the authority to lend to “any individual, partnership or corporation” was changed to “any participant in any program or facility with broad-based eligibility.”
DFA expressly prohibits the Federal Reserve from using 13(3) to support individual institutions. The legislative record on this provision indicates that Congress’ intent was to rule out the sorts of interventions that the Federal Reserve implemented to support the sale of Bear Stearns to JP Morgan and the backstop that was provided to AIG.
The Treasury secretary now has to approve any use of 13(3) — authorization for it is now shared — and “programs intended to support a single institution are specifically prohibited.” There are also greater disclosure and tighter collateral requirements.
And what would have happened the last time round had this change already been in place? …
In particular, the Federal Reserve could not have supported the Bear Stearns transaction, the backstop for AIG would not have been possible, the guarantees provided by the TLGP program would have required Congressional approval, and the ring fences provided for assets owned by Citi and the Bank of America would not have been possible.
3) The FDIC now has orderly liquidation authority (OLA) to wind down a financial institution, but assistance can only be applied once it is already placed into receivership by the regulator.
Previously the FDIC could help open banks prior to receivership whenever the Treasury secretary deemed that an institution was important enough that its failure would threaten “serious adverse effects on economic conditions or financial stability”.
Now it can only step in to help wind down a financial firm, and Congress has to approve the maximum amount of debt guarantees that the FDIC can provide to solvent institutions once the process has begun.
There’s also the problem of the uncompleted “living wills”, which are supposed to guide regulators in the unwinding of an institution. But the largest financial institutions haven’t finished writing them yet.
And nobody really knows what would happen to the foreign subsidiaries and other cross-border operations of a US firm that’s being wound down, an echo of one justification we remember hearing for the Administration’s unwillingness to nationalise US banks when they were on the brink of failure in early 2009.
Finally, the FDIC traditionally has handled the winding down of small banks, and it’s unclear how well prepared it would be to handle the dissolution of a Too-Big-To-Fail kind.
And near the end of the note, Alexander reminds us that the Fed has new authority under Dodd-Frank to provide liquidity for central clearing houses and other payment and settlement organisations in “unusual and exigent” circumstances — which is at least one area in which it is better prepared to help individual financial institutions.
A few more thoughts
Just to state the obvious one last time, the whole reason for an exercise like this now is that we are indeed faced with the very real possibility of a financial crisis in the US caused by events in Europe. What follows is pure speculation on our part, but here it is.
Last week Gavyn Davies wrote that the outcome of the summit could be that the eurozone’s problems will go from being acute to chronic (see also FT Alphaville). It’s unlikely that anyone was deluded about the extent to which it solved any of Europe’s underlying structural problems, but maybe it pushed back the reckoning for a while.
But one reaction we had to this note is that even merely postponing the ultimate outcome, whatever it turns out to be, was a good reason for US financial markets to breathe a sigh of relief for now.
For one thing, it gives policymakers a bit more time to work out the mysterious bank exposure to Europe. Maybe they’ll never know what it is — actually we think that’s the likely case — but there’s a chance they’ll at least come closer.
The Fed’s latest round of stress tests included a sensitivity analysis for a deep eurozone recession, but the results won’t be out until March. And yes, we know: a) that might be way too late, and b) we might have the same methodological problems referenced above given that the banks are charged with performing the tests themselves.
In the meantime, the banks can continue shedding exposure if they think it’s necessary and US money market funds (many of which are sponsored by large banks) can continue retreating as a source of wholesale funding for European banks, as they are likely to.
In addition, we explained previously how the deleveraging we’ve been seeing by the American subsidiaries of European banks has thus far been moderate and gradual. They’ve shed some securities, but it hasn’t been a fire sale, and they haven’t much constricted direct lending just yet. Should this steady pace continue, the US banking system is indeed better positioned to fill the gap than it was a few years ago.
None of this is terribly comforting, really. The US might be reasonably well-prepared to handle a moderate amount of financial turmoil or a moderate recession in Europe, but it’s doubtful that even the trends we just noted would be able to stem catastrophe here if there’s catastrophe there. And the waters remain as difficult to sail as ever for policymakers, whose navigational tools have now been blunted.
Even so, it’s good to stop now and again to assess where we are.
And on that note, appropriately enough, we’ll accept one of Alexander’s conclusions as our own:
The range of potential outcomes for the US financial system and economy is now more extreme.
Related links:
The epistemology of US bank exposure to Europe – FT Alphaville
Nomura on European bank deleveraging and US loans – FT Alphaville