Wamu's Collapse Wouldn't Have Happened with Today's Regulatory Landscape

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It is not surprising, especially in an election year, to see politicians and others demonize banks and call for them to be broken up. The memory of the 2008 crisis — when banks around the globe suffered over $500 billion in subprime-related losses, resulting in bank failures and bailouts — is still fresh.

But despite proposals unveiled at both the Democratic and Republican conventions to return to some version of Glass-Steagall, which would restrict the activities of bank holding companies, the reality is that much has already been done to protect the industry and public at large from the systemic risk posed by "too big to fail" institutions.

Critics act like policymakers had no response to the crisis. But the truth is Basel III was a significant strengthening of capital requirements; the Dodd-Frank Act has led to tougher prudential requirements for large firms, living wills, a new bail-in regime and other reforms; and annual stress tests further strengthen capital. Dodd-Frank has also significantly curtailed the type of trading and investing activities banks can participate in, albeit through the painfully complex restrictions of the Volcker Rule.

Yet these safeguards have done little to satisfy populist candidates and, notably, Minneapolis Federal Reserve Bank President Neel Kashkari.

Kashkari argues regulators will not actually enforce the new "bail-in" rules, and therefore another round of taxpayer bailouts are inevitable. Although he agrees that the regulatory reforms since the financial crisis are headed in the right direction, he fears that come the next crisis the government will once again be put in the position either of rescuing big banks or risking broader economic collapse. 

The underlying logic of this theory is that many global banks still pose a systemic risk simply because of their large size related to gross domestic product. Pressure to bail out banking giants in the crisis was even bigger in countries like Ireland and Iceland. Italy currently faces a looming crisis with its large banks struggling and serious talk of a publicly funded bailout growing.

More than 50 groups (including economists, financial experts and finance industry groups) have also called for larger banks to be broken up.

Still, leaders around the globe, including Kashkari's peers at the Fed and Christine Lagarde at the International Monetary Fund, argue that clear and intense regulation will result in stronger banks and a more stable system. 

Who's right? To decide, let's use a real-life example of a bank that did fail during the crisis to see what the impact would have been of new rules put in place since the crisis.

Washington Mutual, one of the most aggressive mortgage lenders prior to the subprime crisis, went into distress in 2008 and had to be resolved by the regulators, becoming the biggest bank failure in U.S. history.

At the start of the crisis, Wamu had risk-weighted assets of $240 billion, tangible common equity of $16 billion and ultimately over $31 billion of subprime mortgage losses. If Washington Mutual had been regulated to current standards and rules:

  • Risk-weighted assets would likely have been closer to $260 billion under the more conservative Basel III rules.
  • Tangible common equity would likely have been closer to $26 billion.
  • The combination of capital and bail-in debt would have been closer to $52 billion (20% of risk-weighted assets).
  • Liquidity — Wamu's key pressure point when over $16 billion of deposits were withdrawn during one critical week — would have been strengthened under Basel III's "liquidity coverage ratio," which requires at least a 30-day liquidity buffer.
  • And perhaps most important, as Wamu embarked on its aggressive growth strategy in subprime lending in 2004, the annual stress tests under the Fed's Comprehensive Capital Analysis and Review would have presumably triggered warning signs, such as over $30 billion of exposure versus tangible common equity of about half that amount.

True, the effectiveness of the reforms such as the bail-in regime will be realized if regulators enforce them. Kashkari's main concern seems to be that regulators will not be willing to bail in debtholders for fear of tainting the market and causing a reputational "bank run" from such securities.
But I believe such reforms are already having a positive effect on the market. All newly issued bank securities now include a clause about what would happen if the financial institution is no longer viable. The risk of debt being converted into equity through a bail-in process is being priced into certain securities. Considering these developments, on what basis could a regulator waive enforcement?

 There is concern, however, that the timeframe for regulators to take action in the next crisis may be even shorter than in the last crisis, given market forces. It is likely that long before a "nonviable" pronouncement is handed down by the regulator, the capital markets will be pricing this heightened risk into the bail-in securities.

The best path forward then is to fully operationalize the new regulatory framework and closely monitor the progress of the big banks.

Brian O'Donnell is executive-in-residence at the Global Risk Institute.

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