How a Big-Bank Failure Could Unfold

Next we will learn of Taunus - known as Deutsche Bank

By MARC JARSULIC and SIMON JOHNSON

Marc Jarsulic, chief economist at Better Markets, is the author of “Anatomy of a Financial Crisis.” Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
Defenders of big banks are adamant that we have fixed the problem of too big to fail. Organizations such as the Bipartisan Policy Center and the law firm Davis Polk & Wardwell assert that the critical breakthrough was the introduction of new orderly liquidation powers under the 2010 Dodd-Frank financial reform legislation, enabling the Federal Deposit Insurance Corporation to handle the resolution or managed failure of very large financial companies.

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This is the core of their argument that no financial reforms or higher capital requirements are needed. This discussion can get a little abstract, so to understand the details – and why the bank advocates’ position is wrong – consider what could happen if there were a hypothetical problem at a major international financial conglomerate such as Deutsche Bank or Citigroup.
Deutsche Bank is not currently in obvious trouble, but during the financial stress and instability at the end of 2008, the Taunus Corporation, the American subsidiary of Deutsche Bank, looked very vulnerable to the financial storm building around it. Although the bank had more than $396 billion in assets, making it one the top 10 bank-holding companies in the United States, it had equity of negative $1.4 billion on an accounting basis (i.e., its assets were worth less than its liabilities).
A large fraction of Taunus’s liabilities, perhaps $294 billion, consisted of short-term dollar borrowing, in the form of uninsured deposits at its essentially unregulated branch and agency network, along with what is known as repo and commercial paper borrowing.

It was not clear how much help Taunus’s thinly capitalized global parent could or would provide. But the United States government did not choose to find out, because bankruptcy accompanied by distressed sales of hundreds of billions in dollar-denominated assets could have produced another Lehman-like shock.
Instead, the Federal Reserve stepped in to replace short-term creditors that chose to run on Taunus. Taunus borrowing — through the discount window, the Term Auction Facility, the Primary Dealer Credit Facility, the Term Securities Lending Facility and Single-Tranche Open Market Operations — peaked at $66 billion in October 2008.
The Federal Reserve also began huge currency swaps with the European Central Bank, making it possible for Deutsche Bank to swap euros for dollars and meet the dollar funding needs of Taunus (see this speech by the Federal Reserve governor Jeremy Stein, from December 2012).
Deutsche Bank (and indirectly Taunus) was also greatly assisted by the Fed and Treasury decision to rescue A.I.G. Deutsche Bank received $11.8 billion as a result of that rescue (in payments covering A.I.G. credit default swap and securities lending obligations that otherwise would not have paid out).
Taunus received this help from the United States government because its failure would have intensified an already chaotic financial situation. It was not provided because the Federal Reserve knew that, once the storm passed, Taunus’s assets would be sufficient to repay its creditors. Accounting data said otherwise, and it was not possible for the Fed or anyone else to estimate the fundamental values of the assets located in the 180-odd Taunus subsidiaries. Taunus got United States government support because it was simply too big and too interwoven with the American financial system to fail.
We are now told by responsible government officials and leading bank lobbyists that the era of too big to fail has come to an end, because of Dodd-Frank legislative prohibitions on the rescue of individual companies, together with the legal authority of the F.D.I.C. to prevent the disorderly bankruptcy of big American financial companies by putting them into receivership using the new Orderly Liquidation Authority.
But the case of Taunus-Deutsche Bank illustrates that it is far from clear that these new provisions really signal the end of too big to fail. Officials are making promises not to provide what may be considered “bailouts” — but are these promises really credible?
It is true that Fed lending can no longer be funneled directly to a failing A.I.G.-type company, and we fully understand that the recently proposed requirements for foreign banking organizations doing business in the United States are designed to make banks like Taunus less likely to fail.
But the rewritten provisions of Fed emergency lending authority explicitly allow it to establish widely available lending facilities of exactly the type that helped keep Taunus afloat – with the difference being that the A.I.G. funding was company-specific, while Taunus was saved by lending programs available to a broader class of institutions or covering a class of assets.
The Fed will now need the agreement of the Treasury secretary before setting up the facilities, lending is restricted to solvent firms and chief executives may be required to certify solvency in writing. But solvency is an ambiguous concept in a crisis. It is hard to imagine that this will slow down bailouts by more than 15 minutes.
The F.D.I.C. will, in the future, be able to guarantee the debt of solvent distressed banks through programs like its Temporary Liquidity Guarantee Program, which guaranteed hundreds of billions in unsecured bank borrowing during the crisis. The F.D.I.C. will now need the agreement of the Fed, the administration and Congress to establish the program. That might take a day or two.
Given circumstances similar to 2008, is it likely that Congress and the administration will choose to stand in the way of efforts to prevent a systemic meltdown? Would there be any serious resistance to deploying trillions dollars in loans and guarantees to keep big banks from failing?
If the Treasury secretary, the chairman of the Federal Reserve Board and the president of the New York Fed all attest, as they did in fall 2008, that the alternative would be the end of the world’s financial system, Congress will acquiesce.
Nor is it obvious the Orderly Liquidation Authority would be able to wind down one of our large banks during a crisis. If past events are a guide, Citigroup will be one of the failing. It has its $1.9 trillion in assets dispersed across 2,372 subsidiaries that span the world. Just like any other company operating across borders, it is subject to the bankruptcy code and other laws of foreign jurisdictions where it does business. In the case of Citigroup this includes Britain, Germany, Hong Kong, Japan and other places.
So to smoothly “resolve” the Citigroup holding company, all the foreign jurisdictions, including creditors and courts, would need to stand back and allow the F.D.I.C. to determine the priority of claims under its Orderly Liquidation Authority.
Other jurisdictions might agree to some or all of this in a period of calm, but will they follow through if there is a general crisis?
When the F.D.I.C. says that a complex institution like Citigroup is insolvent, the amount of total losses will be unclear, and the harm to individual bank counterparties will be hard to forecast. If foreign regulators can preserve the interests of domestic creditors and counterparties of Citigroup by winding up Citigroup subsidiaries under domestic law, won’t they have very strong incentive to do so?
The legal changes of which large bank supporters are most enamored, and which they contend are sufficient to end too big to fail, both suffer from potential time inconsistency. That is, they rest on promises that are unlikely to be fulfilled at the crucial moment.
Federal authorities have promised not to come to the rescue of large failing financial companies, but they still have more than enough permissible lending authority to do just that. And if that authority proves insufficient to the task, they will have every reason to expand it.
Foreign authorities may promise to allow the United States to resolve global banks under the Orderly Liquidation Authority, but when the time comes to use it, they are likely to have good reason to find a way around their agreements.
The Dodd-Frank Act does give regulators other authority that can effectively reduce the risk posed by large banks and nonbank financial institutions. Those institutions can be required to finance their operations using substantially more equity, thereby changing their incentives and buffering themselves and the public against their miscalculations. Their use of short-term debt can be constrained so that they can survive runs by uninsured short-term creditors. And if they cannot develop a credible plan for orderly resolution in the event of failure, they can be required to divest assets and activities to make such a resolution possible.
To date regulators have made only limited use of this authority. They need to do far more.