Wharton's Peter Conti-Brown and Carnegie Mellon's Allan Meltzer discuss new rules designed to contain the fallout from bank failures.

A proposal in early May from the U.S. Federal Reserve to prevent automatic cancellation of mostly derivatives contracts when a large bank fails aims to contain the fallout. When a bank enters bankruptcy or a resolution process, the regulator says it wants to prevent a disorderly unwinding of the bank, asset fire sales and the spread of financial risk across the system that automatic cancellations could induce.

At present, contractual provisions typically require banks to settle their dues if they default. A triggering event like a bank bankruptcy could create a run on the financial institution and its subsidiaries, and that is what the Federal Reserve wants to prevent, say experts at Wharton and Carnegie Mellon University. However, regulation alone is not enough to avert financial crises, and higher equity capital is the surest buffer against them, they said.

Peter Conti-Brown, Wharton professor of legal studies and business ethics and author of the book The Power and Independence of the Federal Reserve, explained the importance of the proposal. “It is the opposite of one of the fundamental legal devices in bankruptcy, which is called the automatic stay,” he said. “Any time [a firm] files for bankruptcy, all the creditors who have been circling around the assets of the firm, hungry for repayment, have to stop and take a break — it’s an automatic stay. That didn’t apply to derivatives. The cancellation of the immediate repayment clauses in these contracts is trying to duplicate the automatic stay in bankruptcy.”

“When a bank fails, no one will take its paper and [others in the market] begin to believe that maybe the other banks have bad paper, so the system closes down,” added Allan H. Meltzer, professor of political economy at Carnegie Mellon University’s Tepper School of Business. “The problem here is not a bank failure, as much as it is a failure of the payment system — that no one will accept payments from another bank because they don’t know if they will be able to honor them. That is what we want to prevent.”

All the regulation of risk-taking by a particular bank may be helpful but it doesn’t get at the central problem, said Meltzer, who has served as a consultant to the Federal Reserve, the U.S. Treasury and several Congressional committees, among other roles. “The central problem is the spread of the problem from one bank to other banks. It is about systemic risk — risks to the system and not about risks to the individual banks.”

Conti-Brown and Meltzer discussed the context and need for the Federal Reserve’s proposal on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

“The idea (of the Federal Reserve’s proposal) is to stop derivatives from being a trigger for spreading financial contagion and trying to relax that pressure.”–Peter Conti-Brown

Adapting to a New Regime

The proposed rule would cover what are called “qualified financial contracts” entered into by “global systemically important banks,” or GSIBs. These contracts are used for derivatives, securities lending, and short-term funding transactions such as repurchase agreements. As of November 2015, there are a total of 30 GSIBs, according to the latest list published by the Financial Stability Board. The comment period on the proposal will be open until August 5. If the proposal takes effect, banks and their counterparties would have to rewrite their contracts to prevent their automatic cancellation in the event of a bankruptcy.

Hedge funds and asset managers who strike such contracts with banks will not like the proposal, according to a Wall Street Journal report. “The proposal would see investment firms lose certain contractual rights to terminate financial deals with big banks — rights that essentially have allowed them to claim payments in the event of a bankruptcy filing without having to stand in line with other creditors,” it said.

Banks that enter into qualified financial contracts “have to be better adapted to what regulators and the government view as the alternative to bankruptcy, should it occur,” which is the Orderly Liquidation Authority that the 2010 DoddFrank Wall Street Reform and Consumer Protection Act created, said Conti-Brown. Derivatives account for between 80% and 90% of qualified financial contracts, he added. “The idea is to stop derivatives from being a trigger for spreading financial contagion and trying to relax that pressure.”

Beyond Regulation, a Call for More Equity

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future,” he said. “The way to get better protection of the public is to require higher equity capital standards [at banks].”

“Since [banks] didn’t have their equity at stake [in the 2008 financial crisis], they didn’t care much about the risks that they were taking.”–Allan H. Meltzer

Conti-Brown agreed with Meltzer. “Debt is the mechanism by which contagion is spread, and the way to contain it is to require banks to have more equity capital,” he said. That would also ensure “more and better oversight from stockholders,” he added.

Conti-Brown viewed the role of regulation differently from Meltzer, though. He said he is “not as skeptical about the utility or futility of regulation because there is some value in [it].” He added that while regulators cannot anticipate new crises, “they are going to be able to see the things they have seen before,” and introduce the necessary reforms. “When they succeed we just don’t ever hear about those.”

Conti-Brown, however, cautioned that relying on regulation alone to prevent financial crises could even be dangerous. “If we are sending a message that there is no more risk of a financial collapse to occur because we legislated that away, then people who heed that message are going to change their behavior in ways that are going to be indeed causing the very thing that [Meltzer] is talking about. If you diminish the leverage, you are diminishing the mechanism by which financial contagion is spread.”

Lessons from the Past

Meltzer recalled a former chairman of the U.S. House Financial Services Committee telling him that some of the banks went into the 2008 crisis with 2% equity — the rest of their capital structure was debt. “Since they didn’t have their equity at stake, they didn’t care much about the risks that they were taking,” he said. Banks that spun off their toxic mortgages to subsidiaries were eventually forced to pick up the losses, he added. Conti-Brown noted that the 2% equity represents a debt-equity ratio of 50:1, which was much higher than the levels of 15:1 used by companies to finance expansions or mergers in the 1990s leveraged buyouts scandal.

Banks have maintained strong equity capital in the past, said Meltzer. He recalled that during the Great Depression of 1929-1932, not a single large bank failed in New York because they had 15% to 20% equity capital. That was before the Federal Deposit Insurance Corporation (FDIC) was created in 1933 as a response to the Great Depression, he said.

“If the management of a bank isn’t cautious, the principal stockholders will [force them to have a higher equity].”–Allan H. Meltzer

Meltzer said that while the current Federal Reserve requirement for banks to have 12% equity is “a lot better than where we were,” the agency could raise that to 15%. Conti-Brown explained how higher equity requirements at banks could help avert crises. “Every time you move those goal posts out, you are increasing equity,” he said. With higher equity, bank failures have to be larger to topple the payment system and create a system-wide crisis, he said. “When you are moving from 12% to 15% [equity], maybe that seems tiny, but there is a world where there are failures and stresses that simply don’t topple our system because of that amount of equity,” he said.

No model exists to define the optimum amount of equity capital for a bank, says Meltzer. “Large banks like Bank of America, Citibank and JP Morgan Chase are much too big for the FDIC to be able to handle and the FDIC knows that,” he said. “We need to have a system in which they manage their own risk. If the management of a bank isn’t cautious, the principal stockholders will [force them to have a higher equity].”