April 24, 2017

Neel down

by Breakingviews.

Two top bankers can’t agree on whether lenders are too big to fail. JPMorgan boss Jamie Dimon reckons the problem is solved. Fed banker Neel Kashkari disagrees, because using debt to absorb losses is flawed. Markets suggest Dimon is closer to the mark.

Dimon argues that banks will not need rescuing again because they have enough reserves and capital to be wound down. Minneapolis Federal Reserve President Kashkari reckons regulators won’t dare use so-called bail-inable debt anyway.Kashkari has reasons to doubt. The insolvency of Lehman Brothers sent shockwaves through money and credit markets. That forced governments to rescue other lenders. He is right that using debt to fund resolutions could amplify shocks, as it is marked down.Yet there are reasons to hope that Lehman-style contagion should be reduced. Banks are now carving out specific tranches of debt, or issuing it from separate companies to prevent resolution destabilizing their main business. Regulations deter them from owning each other’s bail-inable securities.Banks are also better capitalized. In the 2008-09 crisis, average losses and recapitalization costs were between 6 percent and 15 percent of risk-weighted assets, according to the Financial Stability Board. In that scenario common equity would be toast, but bail-inable debt would face modest losses.

The market gives regulators some credit. U.S. banks’ credit default swaps are not baking-in a much higher chance of the government stepping in than they are for ordinary companies. The 10-year credit default swap spread on six large U.S. banks is around 110 basis points, in line with spreads on corporate company debt.

Meanwhile, investors are receiving a premium for debt that is expected to take losses in a bail-in versus that which isn’t, charging banks for the support governments once volunteered. In Europe, the spread between senior debt eligible and ineligible to be hit is about 50 basis points for Santander. Bank of America’s holding-company debt pays a premium of about 30 basis points to its bank securities. Estimates for the historic subsidy for too-big-to-fail banks range from 25 basis points to 80 basis points, according to the Bank of England.

Dimon might still be wrong. Banks haven’t yet issued enough debt. In extreme cases, losses have exceeded bail-inable reserves. Cross-border banks may prove harder to resolve if authorities squabble over losses. Yet bond investors suggest regulators cannot be relied on to wimp out.


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