The Real Weakness of Big Banks Reform Strategy

Anil Kashyap is one of our leading researchers on banks. His book with Takeo Hoshi on the evolution of the Japanese corporate finance is a must read on the twists and turns that built a great economy and then laid it low. And he has many other papers and relevant recent commentary.

Professor Kashyap has a sharp perspective the administration’s financial sector reform thinking, in part because he has long worked alongside key people now at the National Economic Council (the NEC, by the way, has disappointingly little transparency; even Treasury is more open).

So we should take him seriously, writing Tuesday in the Financial Times, on the importance of the proposed new “funeral plans” for banks.

Kashyap’s point is that if banks are forced to explain, in convincing detail, how they can be wound down, this will effectively limit the complexity and scale of their operations. (See “Rapid Resolution Plans” on p.25 of the regulatory reform proposals; p.26 in the online NYT version)

The notion is intriguing, if such rules are actually enforced. Essentially, banks would be required to specify the extent and nature of costs for any bailout they may require.

A key part of any plan would be the people involved. Are there critical individuals who would need to be kept on to wind down positions (as was claimed to be the case with AIG FP)? Would they therefore require large retention bonuses? How large exactly?

You can see how such resolution planning might go wrong – particularly if banks were only forced to consider whatever they now regard as “normal” risks. Remember the head of quantitative equity strategies who said, in early August 2007, “Events that models only predicted would happen once in 10,000 years happened every day for three days.”

A checklist approach is definitely not going to work (been there, done that, for countries). You need something that can simulated or, even better, played out in a war game. Bring in some difficult outsiders and try to break the bank in the messiest way possible (in a game), then follow the consequences and costs.

These banks are so large and intertwined with so many other, it’s hard to fathom how a “funeral plan” would be reassuring – unless it means that they become smaller and less complex.

And this brings up the real weakness of this approach to reform – the political economy. How do regulators of any kind press for meaningful plans regarding closing down, say, Citigroup (C) or JP Morgan Chase (JPM)? The CEOs of those firms have direct access to the Secretary of the Treasury and on Pennsylvannia avenue they are regarded as gurus and bastions of the economy. They’ll say, “look, if you let this person force us to simplify our business, there will be less credit growth and a big recession.” Which recent Treasury Secretary would be able, at that moment, to face them down – particularly as these bankers can, if pushed, go to the big boss?

On top of this, keep in mind there is no cross-border resolution authority currently on the table in the US regulatory reform proposals or at the G20 level. The Europeans say they are inching in this direction; I’ll believe that when I see it. In our next boom-bust iteration, big banks may well be regarded as having ”too many cross-border liabilities to fail”, so there’ll be another quasi-bailout with potentially huge fiscal costs.

And then someone will promise a new regulatory reform plan.

About Simon Johnson 101 Articles

Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at MIT's Sloan School of Management. He is also a senior fellow at the Peterson Institute for International Economics in Washington, D.C., a co-founder of, a widely cited website on the global economy, and is a member of the Congressional Budget Office's Panel of Economic Advisers.

Mr. Johnson appears regularly on NPR's Planet Money podcast in the Economist House Calls feature, is a weekly contributor to's Economix, and has a video blog feature on The New Republic's website. He is co-director of the NBER project on Africa and President of the Association for Comparative Economic Studies (term of office 2008-2009).

From March 2007 through the end of August 2008, Professor Johnson was the International Monetary Fund's Economic Counsellor (chief economist) and Director of its Research Department. At the IMF, Professor Johnson led the global economic outlook team, helped formulate innovative responses to worldwide financial turmoil, and was among the earliest to propose new forms of engagement for sovereign wealth funds. He was also the first IMF chief economist to have a blog.

His PhD is in economics from MIT, while his MA is from the University of Manchester and his BA is from the University of Oxford.

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1 Comment on The Real Weakness of Big Banks Reform Strategy

  1. Simon, I find this less than fascinating, that the ABA, a shill of the oligarchs, would choose to speak and act in such a way. What we need is an equivalent opposing force to offset their rhetoric and power. And, I don’t see one blooming on the horizon, although, inspite of what one blogger said about 30 to 40% unemployment, the actual rate has climbed to 20 with another 5 in the offing, once California is forced to do business exclusively by IOU’s, and the many other states in similar straits go up in smoke. This is just another stage in the upcoming oligarch meltdown. The propup of the economy is falling short and the piper is awaiting payment. Sometime in the next six months, the next crest of the economic tsunami will hit, and then the firebrands will take to the streets. If the single payer folks are vociferous (and unheard), just wait for the next wave, after the remaining taxpayers see what the Congress is NOT doing to get us back on track.

    I feel for Obama. He picked the right people for the job, but failed to understand that Larry and Tim are not “get tough” guys. They are brilliant, but way to close to the forest to hold the trees at bay.

    I am betting that many of those whose rates have just been raised by CITI are going to either (a) default by not being able to keep up, or (b) default intentionally, as a rebellion.

    By the way, you need to look next at the state bond markets, now that most states are running major deficits, and their bond issues can’t get ratings. They will default, and that chain reaction will be spectacular (they can’t find guarantors with their ratings dropping). And this is also true of municipal bond issuers.

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