In A Lehman Do-Over, Fake Bank Still Proves Too Big to Fail

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Larry Summers plays Treasury Secretary at a bank failure simulation set up the the Economist magazine (Economist)

We still don’t know what to do for sure with the Too Big to Fail.

That was the conclusion of a star-studded (well in wonky financial circles anyway) mock, bank-resolution panel in which Larry Summers – a former U.S. Treasury Secretary – played a future Treasury Secretary having to deal with a Lehman Brothers-like collapse. The idea of the panel was to see how regulators would deal with a potential bank failure in the post-Lehman, Dodd-Frank world. The twist is that at the end of the panel there was no real agreement as to whether regulators even with the new rules could do a better job of averting a financial crisis that they did back in 2008.

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The setting is a Friday night in April 2013. The market, which has just closed down 400 points, seems to have lost confidence in fake mega-bank New Jefferson Bank. Fake Treasury Secretary Summers tells the assembled group of bank regulators they have the weekend to figure out what to do to avert a nasty surprise when markets open on Monday. It’s the Lehman nightmare all over again, but not really because we now have Dodd-Frank, which tells regulators exactly what to do. Yes? Not quite.

The whole set up was a good gimmick put on by The Economist at their annual Buttonwood Conference. Perhaps the best part of the bit was that the magazine was able to get a number of people, not just Summers, who had been on the front lines or near it during the financial crisis to play out what they would do were they to be put there again. Donald Kohn of Brookings took the role of Ben Bernanke as the head of the Federal Reserve. John Dugan, who was the head of the Office of the Comptroller of the Currency during Lehman’s actual collapse, played the fake head of the FDIC. Also on the panel were Blackrock’s Peter Fisher playing the head of the New York Federal Reserve Bank, a role that, like Summers, Fisher actually held in real life. Fisher wasn’t at the Fed when Lehman fell. But he did have to lead the Fed’s efforts during the Long-Term Capital hedge fund failure and after Sept. 11. So he knows his share of emergencies. H. Rodgin Cohen, a lawyer at Sullivan & Cromwell who represented many of the banks during the actual financial crisis, was also on the panel as the Treasury’s top lawyer.

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So what happened? There were of course a number of inside jokes. When Kohn and Dugan agreed on a point, Summers said that at least this time around it is nice to see the Fed and the FDIC getting along, which seemed like a dig at former FDIC chairwoman Sheila Bair, who had oddly just spoken at the conference earlier in the afternoon. (It wasn’t clear if Bair stuck around to see the Summers panel. At least I didn’t see her in the audience.) And while the group did come to a conclusion that was different from what happened in Lehman, it wasn’t clear that the outcome would be much better.

First of all, you know those “living-wills” that the banks are all suppose to submit. Well, the group quickly blew through that, giving the impression that no one assembled thought the documents would really give a roadmap for how a large bank could be orderly wound down. Second, it appears Dodd-Frank doesn’t end Too Big to Fail. The only one on the panel who wanted to discuss putting the fake troubled bank into bankruptcy – which would be actually allowing it to fail – was Jerome Powell, who had been an undersecretary of the Treasury under George H.W. Bush. And even he said he thought Dodd-Frank makes it tougher to allow banks to fail, not easier.

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In the end, the group settled for something that they called Option 3, under Title 2 of the resolution portion of Dodd-Frank, which, for you non-banking law scholars, is a scenario where regulators split the troubled bank into a good bank and so-called bad bank. The bad bank gets all the bad loans that are either delinquent or soon to be, and is presumably allowed to fail. The creditors of the bad bank are given equity in the new good bank in exchange for their old bonds, which boosts the capital of the new bank. Stock holders in the old bank are mostly whipped out, and debt holders, many of which are other banks, would be forced to take losses.

But wasn’t even clear that would work. Some of the people on the panel said the restructuring needed to be done would certainly take more than the weekend – at least a week, perhaps more. By then, you might have a full-blown market panic. Summers said forcing banks to take losses on the debt would put other banks in jeopardy, potentially leading to the same financial crisis that we had after Lehman, and requiring another TARP-like giant Wall Street bailout. Others on the panel said they should go for Option 4, which was for the Fed to provide significant financing – essentially a Bear Stearns-like bailout – to entice another bank to buyout the troubled New Jefferson. But Fisher argued against that option, saying a deal like that would have the potential of just transferring New Jefferson’s problems to some bigger bank, which then would have to be bailed out itself in a few months. In the end, Summers said all of the options under Dodd-Frank were problematic. And with that the mock-resolution panel ended.

So will Dodd-Frank save us from the next financial crisis? It appears we will have to wait and see. But it’s not looking good.

UPDATE: The Economist posted video clips of the Summers’ panel this morning.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.

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