In A Financial Fire, Big Banks Will Have An Extra Extinguisher

The Fed wants to make banks “pre-fund” their own bailout should another financial conflagration break out. bestdesigns/iStockphoto.com hide caption

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The nation’s central bank is proposing rules to help ensure that if a big bank were to fail, the costs of a bailout would not fall on taxpayers.

The changes would mark “another important step in addressing the ‘too big to fail’ problem,” Federal Reserve Chair Janet Yellen said Friday.

The rules would force some major banks to issue long-term bonds that — in an emergency — could provide a cushion of capital to cover losses, rather than leaving it to taxpayers.

The Fed is determined to “substantially reduce the risk to taxpayers and the threat to financial stability stemming from the failure of these firms,” Yellen said.

Here are some key points to understand:

• The country has eight “systemically important” banks: Bank of America, Citigroup, Goldman Sachs, JPMorgan, Mellon, Morgan Stanley, State Street and Wells Fargo.
• By the Fed’s estimation, two of those banks have enough capital to cover even huge losses, so they don’t need the extra protections. The Fed won’t say which two are in such good shape.
• If another financial crisis hit the banks, then those other six might need infusions of cash to maintain critical functions until being absorbed by stronger banks.

Back in 2008, taxpayers had to provide that capital cushion. Congress went along with the bailout plan because lawmakers feared that huge banks might collapse and cause panic. But lots of taxpayers hated seeing bankers get such help, and certainly no one wants to have that happen again.

So the Fed is trying to make sure big banks have their own resources to “pre-fund” their own bailouts.

Under these proposed rules, a less-prepared bank would have to issue long-term debt. In case of a failure, that debt could be converted into equity to help a new version of the bank soldier on and keep depositors safe.

“The core of the proposal would require that these banking firms maintain at all times a minimum amount of long-term debt that could be converted into equity,” Yellen said.

If a bank were to fail, its stockholders would be wiped out first and then the bondholders would pay for a salvage operation. The taxpayers could stay out of the whole mess.

Think of it this way: These rules would force big banks to pay for an extra fire extinguisher in case of a conflagration.

But buying fire extinguishers won’t be cheap. The Fed estimates that all together, the less-safe banks are going to need to raise a collective $120 billion in debt. To attract enough people to give them that money, they’ll have to pay out interest — at an estimated cost of $680 million to $1.5 billion a year.

So it will become more expensive for a banker to be a big risk-taker, and more advantageous to be stable and well capitalized.

“By making the failure of even the largest banks more manageable, the proposed regulation will be another important step in solving the too-big-to-fail problem,” Fed Gov. Daniel Tarullo said in a statement Friday.

The Fed will review industry comments for a few months before finalizing the rules. It has not said when that will happen.