2008 all over again and the banks’ fail-safe will be you

A look into the future: British Prime Minister David Cameron’s nightmare has come true; the slowdown in the global economy has turned into a second major recession within a decade. In those circumstances, there would be two policy challenges. The first would be how to prevent the recession from turning into a global slump. The second would be how to prevent the financial system from imploding. These are the same challenges as in 2008, but this time they would be magnified. Zero interest rates and quantitative easing have already been used extensively to support activity.

For now, the United States Federal Reserve, the European Central Bank and the Bank of England prefer not to contemplate this dire possibility. They will deal with it if it happens, but are assuming it won’t.

More explicit plans have been drawn up for the big banks. There has been an attempt to ensure the globally systemically important banks are better prepared to ride out a storm than they were last time.

Reforms pieced together by the global Financial Stability Board under Mark Carney envisage solving the too-big-to-fail problem by requiring banks to hold a lot more capital against potential losses. Instead of a bailout there would be a “bail-in” – investors in the big banks would take the first hit if things went sour.

Speaking in Singapore, Carney said: “We recognise that our success can never be absolute. Specifically, we can’t expect to insulate fully all institutions from all external shocks, however large. But we can change the system so that systemically important institutions, their shareholders and their creditors bear the cost of their own actions and the risks they take.”

Different story
This might be the case in the event that a single big institution goes pear-shaped. But it would be a different story if it were 2008 again.

Here’s why. The assumption is that the requirement to hold more capital will make banks more risk averse. This could well be true today, when memories of the last crisis are still relatively fresh, but as the late US economist Hyman Minsky explained, stability breeds the next crisis. Investors start off being risk-averse but become more emboldened over time.

A second assumption is that the financial sector will accept the new arrangements in perpetuity. History suggests otherwise. Attempts will be made to water down capital requirements, and the banks will become more willing to flex their muscles as memories of the past crisis fade. Controls will be weakened just at the moment they are needed most.

Financial expert Avinash Persaud has identified another serious weakness in the new plans. This has to do with the way in which banks will raise the extra capital.

The traditional way for a bank to hold capital is with retained earnings or financial holdings it can turn into cash quickly. But banks have come up with a way of boosting their capital ratios without the need to hold large amounts of cash or equity. They are issuing bail-in securities, known as cocos (contingent, convertible capital instruments) that convert into equity once a bank’s capital falls below a certain level. Cocos act like an insurance policy that can be cashed in at the appropriate moment.

Pension funds
The hope was that pension funds, which tend to have a long-term outlook, would be the main buyers of the bail-in bonds. But so far they have been snapped up by hedge funds, private banks and retail investors, who tend to be short term in their outlook and especially prone to herd-like behaviour. More and more of them are being issued to meet the demand.

You’re probably thinking what I’m thinking. Investors will pile into bail-in bonds in the way they piled into US subprime mortgages. The bubble will eventually burst, leading to a rush for the exit.

As Persaud notes in an article for the Peterson Institute for International Economics: “On such occasions these securities, which may also have encouraged excessive lending, either will inappropriately shift the burden of bank resolution on to ordinary pensioners or, if held by others, will bring forward and spread a crisis. Either way they will probably end up costing taxpayers no less, and maybe more. In this regard, fool’s gold is an apt description.”

Carney believes the recent G20 summit in Brisbane marked “a watershed in ending too-big-to-fail”. But that’s not the same as solving the problem. Before Brisbane, policymakers knew they hadn’t cracked too big to fail. After Brisbane, they mistakenly think they have. – © Guardian News & Media 2014

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