[R]ecognition of a state of bankruptcy would have the effect of an atomic bomb. Within a minute, economic agents would try to sell their assets, investors would empty their accounts, foreigners would flee, banks would be forced to close their counters. It’s hard to imagine what state of civil war would be the French and European society.

A bankrupt would have more serious than the Lehman Brothers bankruptcy in September 2008 systemic effects immediately.

Or in the original;

[L]a reconnaissance d’un état de faillite aurait l’effet d’une bombe atomique. Dans la minute, les agents économiques essaieraient de vendre leurs actifs, les épargnants videraient leurs comptes, les étrangers s’enfuiraient, les banques seraient obligées de fermer leurs guichets. On a du mal à imaginer dans quel état de guerre civile serait la société française et européenne.

Un état de faillite aurait immédiatement des effets systémiques plus graves que la faillite de Lehman Brothers en septembre 2008.

Up on Jean-Marc Sylvestre’s blog. It is an interesting (and convenient) theory that the French Government cannot admit of its own financial distress and do something about it because it would trigger systemic risk, when several subsequent rating cuts have not had this effect. Sylvestre’s ideal type can only be a naive investor who’s been living under a rock and bases his investments decisions exclusively on Government announcements. In the real world, though, all empirical studies on flights and runs find that investors are informed and that adverse reactions are rather rational and sophisticated.

I especially appreciate likening flights and runs to atomic bombs and civil wars, all within the same paragraph. John Kay has also used the atom bomb comparison to discuss systemic risk recently. Now, perhaps we should pause and think about the level of sustained economic slowdown that would be necessary to actually destroy capital in a magnitude that is comparable to nuclear explosions or a civil war.

The passage ends with a comparison to Lehman Brothers. Now, this is particularly interesting, because Lehman Brothers did not recognize their own financial distress and tried to push it as far back as they could, willingly failing to prepare for insolvency. It was perfectly understandable, though morally reprehensible, when the worst your financial distress is the bigger are your chances are at securing a bailout. This is one of the principal reason why Lehman’s failure to secure a bailout turned out to be problematic; it had failed to act as diligens paterfamilias and prepare for a wind down. Contrary to the exaggerations in Sylvestre’s column, Lehman Brothers’ experience suggests that “systemic risk,” if there is such a thing, is what happens when recognition of financial distress is pushed back until it cannot be ignored anymore,  much like the French Government is doing.


One justification for the very broad powers of the regulators in the Dodd-Frank Act Title II’s Orderly Liquidation Authority mechanisms is that it would allow the FDIC to act very quickly. This usually means “act very quickly once the process is initiated,” but one key aspect of insolvency resolution is that it also has to be initiated quickly, so as to limit shareholder and manager moral hazard to make things even worse.

Yet, the initiation of insolvency procedures in Dodd-Frank follows from a so-called “three key turning” mechanism. The first key is that the Treasury secretary has to suggest that the firm is “in default or in danger of default,”‘ and have consulted with the President (possibly the fourth key). The second and third key are that two-thirds of the Federal Reserve board, and two-thirds of either the Security and Exchange Commission board for investment banks, two-thirds of the Federal Insurance Office board for insurance companies, or two-thirds of the Federal Deposit Insurance Corporation board must have recommended the initiation of resolution procedures. As should be apparent, this process requires the coordination of multiple agencies, and multiple board members, and is unlikely to be triggered rapidly, if only because of coordination considerations.

Moreover, because initiating insolvency resolution is an admission of failure of prior control, and because the costs of delaying the initiation are essentially shifted onto the FDIC that manages the resolution process, there’s incentives not to recognize the insolvency or to keep hush about it. This was a huge problem for example during the 1980’s Savings & Loans crisis, where insolvent thrifts remained opened for an average period of 17 months before resolutions were initiated, and in a few cases for as much as ten years. The 1993 FDIC Improvement Act sought to fix this problem, by giving the FDIC power to initiate procedures itself, rather than having to rely on the bank’s primary regulator, and by allowing the FDIC to act before the bank is effectively insolvent through what is called “prompt corrective action.” This has, however, obviously not been a success, as in most cases of bank failures during 2008-2009 there were no prompt corrective actions taken, and procedures were initiated after the bank’s equity had dropped in negative territory. This means that, even without rules that require the coordination of multiple agencies with possibly misalligned incentives, regulators’ incentives and knowledge problem generally pushes the initiation of insolvency procedures back.

We actually do have something close enough to a benchmark to see how hard it might be for all “3 keys” to agree and coordinate. The Systemic Risk Exemption of the 1993 FDIC Improvement Act has a similar mechanism, where it required a two-third vote of the FDIC’s board, a two-third vote of the Fed’s Board of Governors, and the Treasury Secretary who has to consult with the President. Triggering this exemption allows the FDIC to bypass the “least cost resolution” provisions of the FDICIA, and allows it to be more generous with its “insurance” fund, providing larger coverage to “uninsured” depositors than is usually the case. It’s essentially an institutionalized bailout procedure.

Despite the fact that it would have allowed the FDIC a lot more flexibility, the Systemic Risk Exemption was triggered only 3 times in nearly 20 years. All 3 cases are recent, as those are Citigroup, Bank of America and Wachovia. In the case of Wachovia, those powers were ultimately not used, as Wells Fargo purchased it instead. This is suggestive that those powers are hard to invoke and use, and might suggest something about triggering the Orderly Liquidation Authority. On the other hand, it is true that the Systemic Risk Exemption could have been triggered much more often under a director that is more bailout-happy than Sheila Bair was (say, Geithner for example).

Given those features of the Orderly Resolution Authority, there’s a chance that initiation might be delayed. Delayed initiation means larger losses, more adverse market reactions, and stronger temptations to bailout, with accompanying calls for further regulation.

Why am I telling you all this? Well, ZeroHedge posted a very revealing figure, detailing the new European Bank Resolution directives and what could be called its “8 key turning mechanism”…

Yesterday I had the honor of participating in the Charles Street Symposium organized by the Legatum Institute in London, under the topic of “What Would Hayek Say Today (Really)?” . The essay I presented is titled “A Hayekian Critique of the New Financial Institutions Insolvency Policies.” Also check out the other essays, they are all exceptional. My coups de coeur are those of Zachary Caceres and Wolf von Laer.

Thus, the right to terminate or close-out financial market contracts is important to the stability of financial market participants in the event of an insolvency and reduces the likelihood that a single insolvency will trigger other insolvencies due to the nondefaulting counterparties’ inability to control their market risk. The right to terminate or close-out protects federally supervised financial institutions, such as insured banks, on an individual basis, and by protecting both supervised and unsupervised market participants, protects the markets from systemic problems of “domino failures.”

Source: Ireland, Oliver. 1999. “Testimony of Oliver Ireland, Associate General Counsel, Board of Governors of the Federal Reserve System, on the proposed Bankruptcy Reform Act of 1999.” Subcommittee on Commercial and Administrative Law, Committee on the Judiciary. U.S. House of Representatives, March 18.

Qualified financial contracts privileges to avoid bankruptcy stay, greatly expanded by a 2005 amendment to bankruptcy laws, were one of the principal source of so-called “disorderly” liquidation during in Fall of 2008, and the main motivation behind most of the 2008 bailouts. It became a primary source of “systemic risk.” See Roe, Mark J. 2011. “Derivatives Market’s Payment Priorities as Financial Crisis Accelerator.” Stanford Law Review 63 (3): 539-590.

File in “systemic risk exaggerations.”

Source: Cihak, Martin, and Erlend Nier. 2009. The Need for Special Resolution Regimes for Financial Institutions—The Case of the European Union. IMF Working paper. September.

My research is on financial stability, but I like to dabble on the economics of fictional stories every once in a while. This is too good not to share.

“Nuclear power and financial systems both have the capacity to blow up the world.”

John Kay’s column in the Financial Times, or up on his blog. I think this might very well be my new favorite systemic risk exaggeration.

I think discussions on plurality of emission deserve a place back in money and banking classes, especially with regards to modern monetary challenges. In this video, Larry White gives a quick introduction to some of the features of free banking systems.

First, let me tell you that I do think there are much more important subjects to be using your time and energy on than reflecting on hypotheticals in the fantasy world of horror flick monsters.  Still, we’re allowed to have a little fun every once in a while, especially on Halloween, right?

With that in mind, those that know me well know that I both REALLY like economics, and I REALLY like zombies, among other silly things. So when LearnLiberty publishes something like this video it makes me really, really happy. I tried the genre once, too.

Even thought it is fun and awesome to have something mixing zombies and economics, I’m not convinced by the analysis in the video. What I like about zombie fiction is the alternative institutional arrangements that authors come up with precisely because of the breakdown of traditional institutions to support exchange and peaceful cooperation. What is interesting is precisely that there is no more room for money to emerge, and no more room for anything even resembling a market price. It is not whether bullets or shovels will become the new currency. How do you trade and cooperate with one another when there is no significant rule of law left? How do you enforce contracts? What happens to cooperation when your temporal horizon becomes dramatically uncertain?

Anthony Davies asks the question, but cannot answer, of whether zombies face decreasing marginal utility. Of course not! The lights are on but nobody’s home for zombies. They don’t feel needs, they are never satisfied, and know no fear. They are moved only by stimuli and reflex. That is precisely what is scary about them; what happens to traditional defense techniques, strategies and weapons when there is no such thing as dissuasion? What happens when your opponents have perfectly inelastic demand for feasting on your guts? How do zombie apocalypse entrepreneurs solve all of these challenges?

I can’t wait for this project to come out, and hopefully answer some of those questions.

[T]he mischief takes a wide range. Those who have been accommodated with loans must pay, whatever their readiness or ability to do so. Further advances cannot be obtained. Other banks must call in their loans and refuse to extend credit in order to fortify themselves against the uneasiness and even terror of their own depositors. Confidence is destroyed. Enterprises are stopped. Business is brought to a standstill. Securities are enforced. Property is sacrificed, and disaster spreads from locality to locality. All these incidents of the banking business are matters of common knowledge and experience.

Court of Kansas. 1911. Schaake v. Dolley, 118 p. 80, 83 (Kansas denying a charter to a new bank because “the economy could not support another bank”).

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