Economics, Financial Services, Pethokoukis

Why the megabanks will never be allowed simply to go bankrupt

The Dodd-Frank financial reform law requires megabanks to devise “living wills” that explain how the institution could go through an orderly bankruptcy. But after attending a recent FDIC meeting on the matter, economist Simon Johnson is highly doubtful the plans, and thus the bankruptcy option, can work:

The full details of these living wills are secret, known only to the companies and the regulators. … But the discussion at the F.D.I.C. helped make clear that these living wills cannot be credible because the big banks are incredibly complex, with cross-border operations and a web of interlocking activities. When one piece fails, this leads to cross-defaults, the seizure of assets around the world by various authorities and enormous confusion regarding who will be paid what. When any single megabank starts to go down, others will certainly come under intense market pressure, in part because the value of their assets will fall and in part because a sense of panic will spread; this is how such crises become systemic.

All of these effects are exacerbated by the fact that these companies are also highly leveraged, with much of this debt structured in a complex fashion (including through derivatives). The bankruptcy experts at the F.D.I.C. meeting stressed these points in fascinating detail.

So once again the options are bailout then or break up today. Johnson favors the latter, noting that under Dodd-Frank both the FDIC and the Fed have the power to require financial institutions  “to divest certain assets or operations identified by the Board of Governors and the corporation, to facilitate an orderly resolution.”

Follow James Pethokoukis on Twitter at @JimPethokoukis, and AEIdeas at @AEIdeas.

2 thoughts on “Why the megabanks will never be allowed simply to go bankrupt

  1. The operations of these banks may be too complex for Simon Johnson to understand. No fault there. They are not more complex, however, than the operations of many a very large business. I suspect that the operations of Microsoft, Apple, Lockheed Martin, WalMart, and many other important businesses that add to the success of the nation, are too hard for Simon Johnson to understand. That is hardly an argument for breaking them up. It is an argument for not trying to micromanage them from Washington.

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