Six years after the financial crisis first began, bank regulators still struggle over how to prevent a similar debacle. There has been slow progress but no final solution, says Simon Johnson, an MIT professor and former chief economist at the International Monetary Fund (IMF). He spoke with Knowledge@Wharton recently about bailouts and where the U.S. and Europe stand today, following the recent flurry of new banking regulation (in Europe) and the evolution of Dodd Frank legislation.
In part one of the interview, Johnson discusses a recent study he co-authored with Wharton finance professor Todd A. Gormley. Titled, “Ending ‘Too Big to Fail’: Government Promises vs. Investor Perceptions,” it shows that despite governments’ announced positions against bailouts, the markets nevertheless believe the biggest firms will not be allowed to fail. Other recent studies show that this sets up an implied government guarantee that allows mega-companies, and especially mega-banks, to raise funds far more cheaply.
In part two (which will be published next week), Johnson looks at the different approaches regulators take in the U.S. versus Europe, with Europe showing less control of the banks’ risky activities. “In Europe, they’re still shell shocked from the sovereign debt crisis … very scared of doing anything that would destabilize … their recovery. As a result the bankers are able to rather dictate the terms to the regulators.”
Knowledge@Wharton: I’m happy to welcome back to Knowledge@Wharton Simon Johnson, who is an MIT professor and former chief economist at the International Monetary Fund. He’s also a senior fellow at the Peterson Institute of International Economics and a member of the Congressional Budget Office’s panel of economic advisors. Thank you for joining us.
Simon Johnson: Thank you.
Knowledge@Wharton: You are also the author of at least two major books. One is 13 Bankers, which looked at the causes and possible solutions to the financial crisis. The second, White House Burning, looked at the state of play of the federal debt.
There has been sort of a Big Bang in bank regulation in Europe recently. And there also have been a couple of related studies that provide data points to support views that have long been thought to be true, and that now are getting more support.
You are a co-author of one of the studies, along with Wharton finance professor, Todd A. Gormley. That study is called, “Ending ‘Too Big to Fail’: Government Promises vs. Investor Perceptions.” It looks at [the idea] that even though governments may say they are not going to bail out banks [during] a crisis … the markets don’t believe they won’t bail them out. Is that the essence of your study?
Johnson: That’s the question that we’re interested in. We actually looked at Korea and what happened during the Korea crisis of 1997-1998 and then subsequently. And we looked at the chaebol, the big business groups [in that country], most of which don’t have a bank within them. They’re the big powerful players. [They include] Samsung, Hyundai, and at the time, Daewoo. We looked at these because the government said — and the International Monetary Fund strongly encouraged the government to say — “No bail outs. No bail outs for creditors. No bail outs for these big chaebol.”
“The terms of the bailout — what you need to do in order to get it; who we regard as being critical; what justifies a bailout — that’s an important story to tell people….”
Nevertheless, investors apparently believed that threat wasn’t credible. They said, “No — you’re not going to let Samsung go down.” Samsung was regarded by investors as being too big to fail because it was so big. I think that’s the key lesson for banking around the world. If the banks really are big, and if the consequences of them failing would be catastrophic, they’re not going to be allowed to fail. Therefore, now they can borrow more cheaply.
Knowledge@Wharton: How did your study show that was the case – not just in Korea, but in most countries?
Johnson: We’re interested in this phenomenon of too big to fail that people have become focused on because of the financial crisis. In the United States, we focus on the very large holding companies, for example. But I think it’s a much more general phenomenon around the world, where you have some very big firms of different kinds in different places that implicitly have government support.
That implicit support means they can borrow more cheaply, even when everything is fine, because there’s a government guarantee mixed in there. And in a crisis, you actually see who had access to funding, how the funding came to them. The investors were falling over themselves to lend to what they regarded as the very biggest, safest players, including Samsung and Hyundai — and for a while, to Daewoo, although Daewoo actually did end up failing, which is an interesting twist to that story.
Knowledge@Wharton: There is an interesting parallel to this — the second study published at the end of March by IMF. It looked at how much it is worth to have that implied-but-not-stated government guarantee. So, while the government may deny that it will step in, the markets believe it will, and they price their securities, their bonds, whatever it might be, as if it will. The IMF study found that in 2012, the implicit subsidy given to global, systemically important banks represented up to $70 billion in the U.S. and $300 billion in the Euro area. Those subsidies take different forms. Sometimes it’s a direct injection; sometimes it’s a loan guarantee, and there are other forms too.
There is other recent work that notes that, thanks to the government subsidy, the systemically important banks can source capital at somewhere between a half a percent and one percent less than smaller banks or even large regional banks — which is a huge competitive advantage for the mega banks and disadvantage for the other banks.
Johnson: The IMF study is a very good study built on earlier work by Kenichi Ueda at the IMF. But this is the first time they put it together in a broader institutional and somewhat official view. There are lots of academics out there who have tried to measure this. There are people in the industry who have said, “No, no, it doesn’t exist. Nothing to look at here. Keep moving.”
The academic view is, I think, confirmed and expanded by what the IMF has done. They looked at three different methodologies. They found, roughly speaking, the level of implicit guarantee to be exactly what you said, with the primary mechanism being that if I’m regarded as “too big to fail” by the market – [that is,] you think that if I’m failing the government will come and help me and help my creditors — you will now, at a time when nothing bad is going on around the world, lend to me more cheaply by perhaps around 100 basis points, one percentage point. There is an implicit hidden uplift to the quality of my credit [because of] this implicit government guarantee.
It’s a very straightforward point, you might think, but it’s very important to have this from the official sector. Soon, we’re going to have a report from the Government Accountability Office…. I think the Federal Reserve Board of governors will probably have its own report. One or more of the regional feds may have their own reports. The officials find themselves compelled to do careful studies and to produce some numbers. Those numbers are then going to feed into the political process, and they’re going to be an important part of that process.
Knowledge@Wharton: As those studies build and come to similar conclusions, which I assume is what you are suggesting, then there is a stronger and stronger case and it becomes more difficult to have plausible deniability on the part of the banks, who I assume would say that this is a little bit exaggerated.
“The government said … ‘No bail outs.’… Investors apparently believed that threat wasn’t credible. They said, ‘No — you’re not going to let Samsung go down.’”
Johnson: My view, which I’ve been articulating for five years now, is that there is clearly a problem of too big to fail. In fact, the book that tells the story of what happened in September 2008, written by Andrew Ross Sorkin, is called Too Big to Fail for a reason. Subsequently, of course, there were some financial reforms — we had the Dodd Frank reform passed in 2010. I think those moved things in the right direction. But I don’t think they ended the problem.
I’m on the Federal Deposit Insurance Corporation’s systemic resolution advisory committee. We look at the details of the plans to make failure less likely, and what you do with the mega banks when and if they do fail. And I have to say it’s absolutely a work in progress, to be polite — and it is not clear that one of these big banks could fail without big losses for the creditors. The pressure would be for the government to step in to protect the creditors to prevent any kind of spill over within the country or internationally.
Knowledge@Wharton: Recently, the European Parliament has passed a lot of [banking] legislation…. It’s aimed at ending the tax payer bailouts for banks. They are calling it Super Tuesday because it’s so much legislation passed at one time as sort of a Big Bang of banking regulation.
A highlight … is to ensure that stockholders and bondholders are the go-to people first if there’s a bank failure, rather than taxpayers. In emergencies there is a tendency to not want to create more panic by having stocks go down and so forth….
The other big thing I would like to have you comment on is that this [legislation] is meant to create a European-wide banking union.
Is this really the big fix that critics have been looking for?
Johnson: First of all, I’m happy they’re trying to move things forward on this agenda. And I do think creating a unified banking union makes sense. They have to figure out how that integrates with the fiscal accounts. Who’s standing behind the banks that are operated at the union level, which taxpayers are ultimately going to bear the losses for if all else fails?
Knowledge@Wharton: There is, I believe, a 60 billion euro fund that has been created. I don’t know whether that’s anywhere near enough, but maybe you can explain where that fits into it.
Johnson: It’s small. The key issue is obviously to what extent the Germans are willing to pay for either … the mistakes of others, or the mistakes of others that are encouraged by German banks when they do another round of reckless lending. So that sort of issue, I think, remains largely unresolved.
“ … If I’m regarded as ‘too big to fail’ by the market … you will lend to me more cheaply by perhaps … one percentage point.”
On the key issue, though, of the bailing, are we going to bail in creditors and shareholders as opposed to bail them out? In other words if you’re a shareholder, do you get wiped out? If you’re a creditor, do you get converted to equity and have presumably a fall in the value of your claim on that company?
I think they are expressing reasonable sentiments. The problem, though, is one of credible commitments, credible promises. And that’s what we studied in the Korean case. That’s what went wrong in the U.S. in the fall of 2008. That’s my reservation about the current U.S. framework.
You can say all you want, “No, no, when there’s a crisis we’re going to do the bail in. No bail out.” But when the crisis comes and it looks like it’s systemic and it’s spread across all of Europe — you think it’s spread globally. If you’re afraid of the consequences for government debt, you’re afraid of the consequences for the real economy, the pressures of protecting creditors one way or another are enormous. And there are many ways that a modern government can provide some form of bailout without necessarily calling it a bailout. I think that’s where we’re heading, and I think that’s where the Europeans are heading, too.
Knowledge@Wharton: How would you rate the effectiveness of this legislation then? Could you give it a grade or some other way of quantifying how well they did or didn’t do?
Johnson: I don’t grade other countries now. I used to at the IMF, but now I only grade the United States, my own country. The main worry I have in Europe is the state of mind of the regulators. In the U.S., we’ve seen a shift towards pushing for higher capital requirements. Now, you can legislate capital to some degree, but it’s actually very hard to write that in a law. It’s much more about regulatory implementation. And we’ve shifted … towards having more emphasis on a leverage ratio — comparing equity with total assets unadjusted for any kind of supposed risk weighting.
In the United States, we’re going to require that large bank holding companies, at the holding company level, have at least 5% equity. They can still have 95% percent debt, and that’s a lot of debt. You can wipe out that equity fairly easily in the modern world. But that’s a big step.
The Europeans have been quite reluctant to go in that direction. Basil III has a leverage ratio; it’s only 3% equity, 97% debt. They need to move and to be pulled. But they’re very reluctant to go there. And I think it’s this lack of regulatory enthusiasm, of course motivated by the fiscal crisis, by the slowness of their economy and by the fact that their big banks, while a little bit smaller than our largest banks, are bigger relative to their GDP than is the case for our banks. So they are a very bank-dependent set of economies that don’t want to rock the boat. They don’t want to upset the bankers. And the bankers are saying, “Oh, don’t do reform, because we won’t do any lending.” And the Europeans are a little bit stuck on that.