Big banks have finally seen sense in the debate about financial reform. The Institute of International Finance, which represents the world's largest lenders, is pushing for a plan to safely wind down failing financial groups. Constructing a credible cross-border resolution regime is the industry's best hope of avoiding more drastic measures.
Preparing banks for failure is hardly a new idea: policy makers have been pushing it for well over a year. Britain's Financial Services Authority has already asked some large banks to draw up so-called "living wills". But given the industry's just-say-no attitude to most new regulation, its decision to embrace the idea is encouraging.
Winding down large banks is not easy. The failure of Lehman Brothers highlighted plenty of fault lines in the investment bank's internal structure and in the way bankruptcy laws work in different countries. But with the banks on board, constructing a cross-border regime essentially becomes a knotty corporate finance problem: difficult, but not impossible.
Of course, any scheme must be credible. But if a big bank's creditors believe they will suffer in a collapse that should be evident in spreads on the bank's debt, and in the credit ratings awarded to its various divisions. If the threat of failure is not credible, regulators will have to consider more drastic measures for big banks like breaking them up or restricting their activities.
Winding down a large cross-border financial institution may still require some taxpayers' money. Everyone agrees that this cost should ultimately be borne by the industry. But some policy makers, including EU commissioner Michel Barnier, believe the cash should be raised in advance through a levy on the banks.
That would be a mistake. Countries should be free to tax their banks. But diverting the cash into dedicated funds could contribute to moral hazard, because investors might expect it to be used for future bailouts.
By contrast, as long as surviving banks know they are on the hook for the costs of a collapse, they will have an incentive to police the industry, and to urge regulators to intervene quickly. Then the financial system really would be safer.
CONTEXT NEWS
The Institute of International Finance on May 24 called for the creation of a high-level international task force, mandated by the G20 group of leading nations, to come up with a global regime for winding down cross-border financial institutions.
The IIF, which represents some of the world's largest banks, said a so-called resolution regime should ensure that most losses are borne by the failing bank's shareholders and unsecured creditors; give the authorities the ability to intervene early; and minimise the cost to taxpayers.
The IIF said any short-term public money committed by governments should be recovered from the industry. It said the clear majority in the industry favoured collecting such costs after the event, though some banks believed it would be better to raise a bailout fund in advance.
Michel Barnier, the EU internal market commissioner, is expected to propose on May 26 a plan for European countries to raise an upfront levy on banks, the proceeds of which would be paid into national funds. According to the Financial Times, the funds would be used to manage future bank failures and insolvencies.