A Market Solution to Secure Banks’ Future

This article appeared in the Financial Times on May 20, 2009.

How long will the US economy live with a banking system in which some institutions are too big to fail ? Not long,we should all hope, because large banks today, under federal protection, can raise short-term funds more cheaplythan their smaller competitors, which are allowed to fail.

"Too big to fail" is an unstable system. Politically inspired constraints on large banks leave them not knowing whatwill come next out of Washington, while there is no way of knowing whether any given bank is just small enough tobe let go or will be bailed out if it gets into trouble.

But here we are, more than a year after the rescue of Bear Stearns, without a plan for the future except for vague —and, as far as I can tell, totally empty — statements coming out of Washington about tighter regulation. What exactlydoes Washington have in mind?

Here is a proposal, not at all original but deserving of serious public discussion. As a condition of enjoying thebenefits of a bank charter, every bank must issue 10-year subordinated notes equal to 10 per cent of its totalliabilities. The specification can be adjusted, but this one serves to illustrate the proposal. The subordinated debtwould be unsecured; holders would stand last in line among all creditors in the event that a bank had to be shutdown. The sub debt requirement would be in addition to existing requirements for equity capital.

Genuine reform requires that four minimal requirements be met, and the sub debt proposal qualifies. First, banksneed more capital to protect the federal deposit insurance fund. Second, there must be more market discipline: eachbank would be forced to roll over maturing sub debt equal to 1 per cent of its liabilities each year. Third, financialstability requires that a bank not be subject to runs. Sub debt cannot run, because of the 10-year maturity.

Fourth, and critically important, some creditors and not just equity owners must be at risk, which is clearly the casewith sub debt. Sub debt provides much more market discipline than equity, because a bank in trouble with a weakshare price is not forced to do anything. Maturing sub debt, however, does discipline the bank and if the bankcannot roll over the debt, it must shrink by 10 per cent to live within its remaining outstanding sub debt. This systemis stable because any bank can contract by 10 per cent within a year by letting loans run off and/or by selling otherassets. It is highly desirable that contraction be managed by the bank itself and not by regulators.

We cannot depend on regulatory agencies to prevent a recurrence of financial crisis. Ahead of the crisis, regulators,myself included, did not understand the risk of subprime mortgage paper in bank portfolios. Nor did the seniormanagement and directors of the most sophisticated financial firms in the world. This is not the first time regulatorsand firms have failed to assess risk adequately. Large international banks accumulated Latin American loans in the1970s; when Mexico defaulted in 1982 and other defaults followed, a financial crisis was narrowly averted.

Long-maturity bonds create much more market discipline than do short-term obligations. Holders of three-monthcertificates of deposit, for example, assume that they can always exit quickly by letting the CDs mature. It is for thisreason that bond spreads over Treasuries of comparable maturity are systematically higher for longer maturitiesthan for shorter maturities.

Banks hate the idea of a substantial sub debt requirement, because sub debt will be expensive. But bankers shouldthink carefully about their opposition. Would they rather face market discipline from sub debt or much heavierWashington regulation, including opaque and changing rules? Given the scale of our financial crisis and taxpayerlosses, intrusive regulation will be the norm for years to come. Do bankers really want to face unpredictableconstraints such as they have seen on executive compensation?

I challenge leaders of our large banks to support a market-based reform such as the one I have outlined. A return tothe status quo ante, with banks enjoying the benefits of "too big to fail", does not seem likely. Regulators will notdare risk a repeat performance. Bankers who think that their political influence will control the regulatory process arein for a rude surprise.

William Poole

William Poole is a senior fellow at the Cato Institute and distinguished scholar in residence at the University of Delaware. He retired as president and chief executive of the Federal Reserve Bank of St. Louis in March 2008.