Greg Ip

Articles by The Economist’s U.S. Economics Editor

Fighting financial crisis: Don’t look down

leave a comment »

What if there were another Lehman?

Oct 15th 2011 | WASHINGTON, DC | from the print edition

[Greg Ip] ASKED on October 11th how he might have handled the financial crisis of 2008 differently, Mitt Romney, the frontrunner for the Republican presidential nomination, refused to answer “a hypothetical”. He had good reason to prevaricate. The possibility of another crisis, given the euro zone’s woes, remains; the ability of the federal government to respond has changed drastically. The Dodd-Frank financial-reform law gives policymakers better tools to handle the failure of a firm like Lehman, but limits many of the other powers used to contain wider panic.

The Federal Deposit Insurance Corporation (FDIC) has long been able to place a failing bank in receivership and repay depositors while it finds a buyer or winds the bank down. This discourages a bank’s creditors from bolting, sparking a broader panic. But many of the companies at the centre of the 2008 crisis were not banks; the cast included investment banks (Bear Stearns and Lehman), an insurer (AIG) and money-market funds. That left two unappetising choices: bail-out, as with Bear and AIG, or bankruptcy, as with Lehman.

Dodd-Frank provides for this scenario. If a company’s failure poses systemic risk, the FDIC can place it in receivership and either sell it off to another company or place its viable bits in a bridge bank, which it can continue to operate, and the rest in a bad bank. The hope is that this will remove the incentive for creditors to run, precipitating a collapse and contagion.

Whether it will actually work is unclear, since it has never been tried. If it doesn’t, the rest of the official safety net is more threadbare than in 2008, when policymakers pulled out all the stops (see table). Dodd-Frank forbids specific support for a single company, as was done for Bear Stearns, AIG, Citigroup and Bank of America. The Treasury can no longer use its foreign-exchange account to backstop money-market funds—worrying, given the exposure of money-market funds to European banks. Before the FDIC can guarantee financial firms’ bonds, as it did in 2008, it now needs congressional approval.

The Federal Reserve can still lend to banks, and to foreign central banks via swap lines. But to invoke its power to lend

to other companies in “unusual and exigent circumstances”, as it routinely did in 2008 and 2009, it must get the approval of the treasury secretary, and demand enough collateral to protect the taxpayer from loss. Recreating its backstops for money-market funds, commercial paper and asset-backed securities might require such stringent conditions that no one would participate.

Such constraints make avoiding another panic all the more important. On October 11th regulators proposed that a financial firm meeting certain criteria, among them at least $50 billion in assets and $20 billion in liabilities, be classified a “systemically important financial institution” subject to special oversight by the Fed. If the authorities cannot catch big firms, they must try harder to stop them falling.

 The original article is linked here.

Written by gregip

October 13, 2011 at 9:39 am

Posted in Uncategorized

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: