We need to share the bill for bail-outs

We need to share the bill for bail-outs

By John Gapper

One thing we have learnt in the past year is that some banks are definitely too big to fail. We may yet discover something even more disturbing: that some are too big to save.

Tim Geithner, the US Treasury secretary, who has staged something of a reputational recovery this week – helped by the fickle stock market – will this morning testify to Congress on his plans for reforming regulation and gaining more power to wind up insolvent financial institutions.

Mr Geithner has intelligent things to say about how the Treasury and the Federal Reserve could have done a better job of letting Lehman Brothers go down gracefully, and saving American International Group without having to stick to bonus contracts. He wants the US government to be able to seize control of such institutions when spending public money.

The fact that it could not – that it had to lend $85bn to AIG to keep it afloat last September rather than take over the insurance group, and was unable to deal properly with Lehman Brothers – is one reason why he has been in trouble with Congress.

But here is a disconcerting thought. What if the US government, with its balance sheet and its reserve-currency dollar, gained the powers that Mr Geithner and Ben Bernanke, chairman of the Federal Reserve, seek? Would that be enough to guarantee that it could resolve the next AIG-style crisis? Unfortunately not.

This crisis, with its discoveries that the UK arm of Lehman Brothers was beyond the reach of the Fed, and that AIG booked many credit derivatives trades through a London-based French banking subsidiary, showed that such institutions have outgrown the US. They not only have many foreign subsidiaries; they have woven a global web of financial contracts.

That makes it very hard to take control of them, even if American taxpayers were sanguine about their money being used to pay off foreign counterparties, which their politicians are not. Nationalisation may not be enough to corral them; it would require internationalisation.

The fact that there is, in this sense, no such notion as internationalisation is the problem. No cross-border body exists with the authority or resources to take over a global financial institution, wind it down safely and divide the bill fairly among taxpayers of many countries.

The “resolution authority” Mr Geithner and Mr Bernanke have teamed up to obtain is modelled on the Federal Deposit Insurance Corporation, the agency that winds up insolvent banks in the US. The FDIC has extensive powers to seize banks, turf out their managers, hand over the assets and liabilities to other banks and absorb any losses.

It did that last week, for example, with Colorado National Bank of Colorado Springs, whose $83m (€61m, £57m) in deposits and four branches were forcibly handed over to Herring Bank of Amarillo, Texas. The FDIC will cover 80 per cent of losses – some $9m – out of its insurance fund, to which US banks all pay levies.

This kind of approach would be a great deal better than the desperate improvisation we witnessed last autumn. Investment banks could be helped to avoid going into Chapter 11 bankruptcy protection without having to cover all their liabilities.

As Mr Bernanke pointed out to a House committee on Tuesday, it would allow the government to rip up obnoxious contracts, such as AIG’s guaranteed retention bonuses, and impose some losses on creditors and counterparties, such as holders of AIG’s credit default swaps.

But resolution authority may not be sufficient. The Colorado National Banks of the world are conveniently small and self-contained, with a ready buyer to hand once losses are covered . Lehman and AIG, however, were not tiny domestic outfits.

Take Lehman. On September 15, when its holding company went into Chapter 11 bankruptcy, the New York Fed, under Mr Geithner, tried to keep its investment banking arm going so that it could be wound down in an orderly way. The Fed failed, for reasons that are instructive.

Although the Fed propped up the US broker-dealer operations, it found that it could not effectively fund the UK arm, which had depended on the bankrupt holding company for cash. It also faced obstacles in dealing with the German banking subsidiary, Lehman Bankhaus.

Resolution authority would have helped, since the government could have – and presumably would in any future case of a Wall Street collapse – stood behind the holding company and backed the foreign subsidiaries through it. That would not, however, guarantee that it could catch all of the overseas entities through which such institutions trade.

Even if it could, there is a political problem. Congressional unrest is growing over the fact that the US government paid off AIG’s CDS counterparties, including foreign banks led by Société Générale and Deutsche Bank, at par. It was being a good global citizen, but that does not earn you points on Capitol Hill.

If you seek to limit global financial risk, it is sensible not to make any distinction between counterparties on the grounds of nationality. Try telling that, however, to taxpayers who must contribute billions of dollars.

A theoretical solution would be to have a global financial authority, with powers akin to the International Monetary Fund, that could salvage a global institution and apportion the costs appropriately. That, however, is not politically achievable, even if it would work in practice.

Perhaps another way can be found to split the bill when one country pays to prop up another’s banks. I am not holding my breath but without it no government can be sure, however enormous its domestic powers, of solving the next AIG.