President of the European Central Bank Jean Claude TrichetVirginia Mayo
The problem of "too big to fail" is proving to be a question that is too hot to handle.
Missing from the Basel Committee on Banking Supervision's otherwise resolute response to the challenge of heading off another financial crisis is agreement on how to contain banks, insurance companies and hedge funds that are so large that their failure would shake the global economy.
The 27 central banks and financial supervisors that make up the Basel Committee said on the weekend that "work continues" on how to subject "systemically-important banks" to more rigorous standards than those faced by smaller institutions.
That's not because authorities are afraid to lean on the banks: the Basel Committee's governing body, led by European Central Bank president Jean-Claude Trichet, agreed on Sunday to more than double the amount of capital that banks will have to keep in reserve to cover losses and buttress economic shocks. These new rules are not expected to pose any problems for Canada's banks.
To Morris Goldstein, a senior fellow at the Peterson Institute for International Economics in Washington, the absence of a concrete response to an issue so central to the financial crisis shows the debate about "too big to fail" has become too charged, making it one that will have to be settled ultimately by politicians.
"If they were further along, they would have announced something; they didn't, which makes me think it's dicey," said Mr. Goldstein, a former IMF official who specializes in international capital markets. "'Too big to fail' is the issue that risks getting kicked down the road. But it remains important."
Two years ago this week, the collapse of investment bank Lehman Brothers exposed the policy challenge of dealing with troubled megabanks.
Seeing no way to prop up the investment bank, the U.S. government allowed Lehman to collapse, triggering the financial crisis that resulted in the deepest global recession since the Second World War. Of course, propping up an essentially insolvent bank could have been seen as just encouraging more risky behaviour.
But in the aftermath of the crisis, the Group of 20 economic powers effectively turned its back on free-market doctrine, promising to keep all systemically-important institutions afloat in a bid to calm investors' nerves. Governments and regulators have since effectively acknowledged that financial institutions that are too big to fail are a reality by ignoring calls to break up big banks, and instead pledging to single out such institutions for special supervision and regulation.
"We're going to continue to have large institutions of global significance that - in a real crisis - regulators can't allow to go under," said Douglas Elliot, a fellow at the Washington-based Brookings Institution and a former investment banker. "We should try to make those institutions as safe as we reasonably can without throttling the economy."
Unlike the rest of the regulatory agenda, which mostly has been laid out in detail by the Basel Committee, the issue of what to do with systemically-important institutions could fall into the laps of G20 leaders when they next meet in Seoul in November.
Central bankers and regulators sounded a steadfast note on the issue after their meeting Sunday in Switzerland. The Basel Committee's statement said systemically-important institutions "should have loss-absorbing capacity" beyond the new standards, which would force all institutions to eventually hold capital that can easily be sold at levels equivalent to 7 per cent of assets.
This is partly recognition that the biggest banks and insurance companies pose an out-sized risk to the financial system, and therefore need larger buffers It is also meant as a charge for the benefit these institutions get from being too big to fail: Their cost of borrowing tends to be lower because investors know the biggest banks are assured a government backstop.
Mr. Trichet's advisory group said Monday that the Basel Committee and the Financial Stability Board, another international body of regulators led by Bank of Italy Governor Mario Draghi, are working on an approach to dealing with systemically-important institutions that could include surcharges on size and requiring them to hold contingent capital, which is debt that converts to equity at times of stress.
But central bankers and regulators likely will stop short of making firm recommendations about what to do with banks that are too big to fail, said Ian Lee, a professor at Carleton University's Sprott School of Business and a former banker. That's because singling out the banks and other financial institutions that should face such extra charges would be an extremely controversial decision.
Prof. Lee foresees a political quagmire with banks fighting to stay off the list and elected governments coming under attack from opponents for either treating the institutions too gently or putting big lenders at a global disadvantage by subjecting them to tougher restrictions.
"I will confidently predict that they will not come up with an agreement on this," Prof. Lee said from Ottawa. "It's too contentious and too dangerous for both the big banks and the finance ministers. They will kick it down the road."
Banks will fight to stay off the list, and governments might even seek to shield them