If you heard the Federal Deposit Insurance Corporation -- the grim reaper of banks -- was establishing a presence in your bank because it feared its collapse, what would you do? That's easy: you would withdraw all of your funds as quickly as possible. So would everybody else. That's called a bank run.
A similar problem may be looming for the FDIC's new authority as the liquidator of giant non-banks financial firms. It recently released a narrative (.pdf) of how the resolution could have worked with Lehman Brothers. But would it simply have triggered an earlier bank-run like scenario instead?
To be sure, some seriously tough challenges lie before the FDIC when attempting to prevent a gigantic financial firm from failing outright. First, regulators must identify that a firm is fatally wounded before the market does -- good luck with that. Then, it must muster up the political will to try to take over that firm. And this isn't the Eighth Savings Banks of Pawnee, Indiana we're talking about here, it would be a huge global institution with political influence, lobbyists, and very powerful clients.
But even once it has managed to beat all odds, it must then establish an on-site presence in order to conduct resolution-related activities, like pouring over its books and preparing its financials for a speedy acquisition. Expanding on a blog post written by University of Pennsylvania Law Professor David Skeel, who is deeply skeptical about the FDIC's liquidation authority, John Carney of CNBC's NetNet writes about the challenge this on-site presence poses:
Of course, the moment this happened, Lehman would have seen its access to funding collapse, its counter-parties immediately demanding collateral, and its customers closing off accounts. In short, Lehman would immediately collapse because the FDIC's establishing an on-site presence would trigger a run on the bank.
The FDIC has actually already anticipated this criticism. It claims:
The development of additional information to facilitate a potential resolution would be done in a manner that would not disrupt the business operations or indicate an imminent failure of the financial company. As regulated entities under the Dodd-Frank Act, heightened supervision by the FDIC, the Federal Reserve, and other prudential regulators will be normal. As a result, these information-gathering activities should neither signal increased distress nor precipitate market reaction.
In other words, the FDIC says the market wouldn't notice its presence, because it will have an ongoing presence in the systemically vital institutions that it might have to one day resolve.
This might be true, but it's hard to imagine that market rumors wouldn't surface if some employees at Lehman had noticed a few more FDIC employees than usual arriving at their New York office one morning via the Acela from Washington. They tell a few friends, and their friends tell a few more friends. Before you know it, the run has begun.
With that said, there was plenty of speculation that Lehman would fail as soon as the Bear Stearns collapse occurred. For months, people were saying that Lehman was next. But catastrophic panic didn't occur until relatively late in the game -- well after the spring of 2008, when the FDIC says it would have begun working on Lehman's liquidation.
Moreover the FDIC would have had a stronger presence at pretty much all big banks at that time. It certainly would also have beefed up its staff at Merrill, Citi, Bank of America, and probably even Goldman Sachs. So would the financial crisis have simply begun sooner?
And that's the real problem with the resolution authority -- if a liquidation triggers a domino effect. The FDIC cannot possibly resolve the entire financial sector all at once. A resolution or two cannot calm panic: they may even cause it. In a scenario like we had in the fall of 2008, the FDIC would be left impotent. So we must ask again, how can a bailout be prevented?