82nd International Atlantic Economic Conference

October 13 - 16, 2016 | Washington, USA

Evidence that "too big to fail" remains firmly entrenched in Europe

Saturday, October 15, 2016: 10:40 AM
Edward J. Kane, Ph.D. , Carroll School of Management, Boston College, Chestnut Hill, MA
In the wake of the Great Financial Crisis, authorities in the US and EU have waged war on the presumption that many of the world’s most important banks are too vital economically, too complex structurally, and/or too politically powerful to fail and unwind(TBTFU).  In both venues, regulators extol new laws and directives designed to impede bailouts, to convey new resolution authority, and to require megabanks to strengthen their capital, their liquidity, and their “resolvability.”

But the incentives for top regulators and distressed bankers to hide losses and delay resolution are as strong as ever.  Especially because distress is systematically under-reported, the high percentage of non-performing loans and deferred-tax assets on the books of leading banks in countries such as Italy and Portugal supports two inferences:(1)that the EU is harboring a horde of zombie institutions that authorities are unwilling to put into resolution, and(2)that these zombies can continue in business only because creditors continue to believe that in a crisis some government or other will step up to protect them.  Obviously, raising capital requirements and making bail-ins more feasible constitute only half an answer.

The other–and still missing—half of the answer is to impose new duties and sanctions on individual regulators and bankers.  Authorities need to make tail risk visible to regulators at the individual-institution level.  In particular, a positive obligation might be placed on every bank’s top officers to certify personally the material accuracy of marked-to-market estimates of bank net worth, to prepare frequent estimates of the capitalized value of the implicit guarantees the bank enjoys, and to report promptly all substantial changes in risk exposures and net worth to regulators.  Because mark-to-market estimates are especially hard to verify for complex institutions, complex firms should be asked to post proportionately higher levels of accounting capital and their officers should be subject to severe penalties for concealing material adverse information.

Given this information, government regulators could be assigned three specific tasks:(1)to aggregate in a reproducible manner estimates of the opportunity-cost value of safety-net risk exposures in individual banks,(2)to recover these costs, and(3)to continue to use traditional regulatory controls to prevent tail risks from becoming dangerously large.  Accountability could be enhanced by having megabank and regulators’ calculations audited by private accounting firms and by offering top bankers and regulators a fund of deferred compensation that would be forfeit if statistical analysis or subsequent events could prove that critical risk calculations were fudged.