Could Goldman Sachs Fail?

kristy Reforming Global Finance

An article from The Baseline Scenario

Could Goldman Sachs Fail?

Posted: 14 Apr 2011 04:11 AM PDT

By Simon Johnson. This link to MIT Sloan’s website provides a partial transcript and video covering the points made below.

If Goldman Sachs were to hit a hypothetical financial rock, would they be allowed to fail  to go bankrupt as did Lehman or would they and their creditors be bailed out?

I asked this question on Sunday to four leading experts (Erik Berglof, Claudio Borio, Garry Schinasi, and Andrew Sheng) from various parts of the official sector at the Institute for New Economic Thinking (INET) Conference in Bretton Woods and to a room full of people who are close to policy thinking both in the United States and in Europe. In both the public interactions (for which you can review video here) and private conversations later, my interpretation of what was said and not said was unambiguous: Goldman Sachs would be bailed out (again).

This is very bad news  although admittedly not at all surprising.

Why wouldn’t policymakers allow Goldman Sachs to fail? The simple answer is that it is too big. Goldman?s balance sheet fluctuates around $900 billion; about 1 ½ times the size that Lehman was when it failed. All sensible proposals to reduce the size of firms like Goldman including the Brown-Kaufman amendment to Dodd-Frank have been defeated and regulators show no interest in tackling Goldman’s size directly.

The largest financial institution we let go bankrupt post-Lehman was CIT Group, which was about an $80 billion financial institution. Some people thought CIT should be bailed out; fortunately they did not prevail ? and CIT restructured its debts in November-December 2009 without any discernible disruptive effect on the economy.

Supposedly, the Dodd-Frank financial reform legislation expanded the resolution powers of the FDIC so that it could handle the orderly wind-down of a firm like Goldman, imposing losses on creditors as appropriate ? without having to go through regular corporate bankruptcy (after more than 2 years and over $1 billion in legal fees, Lehman?s debts are still not fully sorted out).

Speaking to a press conference at INET on Friday evening which I attended ? Larry Summers, former head of the National Economic Council, emphasized the importance of this resolution authority.

But the resolution authority would not helpful in the case of Goldman Sachs because it is a global bank operating on a massive scale across borders. Such a case would require a cross-border resolution authority, meaning some form of ex ante commitment between governments. As this does not exist and will not exist in the foreseeable future, Goldman is as a practical matter essentially exempt from resolution.

For a bank like Goldman there remain the same unappealing options that existed for Lehman in September 2008 ? either let them fail outright or provide some form of unsavory bailout.

The market knows this and most people including everyone I?ve spoken to over the past year or so regards Goldman and other big banks as implicitly backed by the full faith and credit of the US Treasury. This lowers their cost of funding, allows them to borrow more, and encourages Goldman executives ? as well as the people running JP Morgan, Citigroup, and other large bank holding companies to become even larger. No one I talked with at the INET conference even tried to persuade me to the contrary.

Given that this is the case, the only reasonable way forward is to follow the lead of Anat Admati and her colleagues in pressing hard for much higher capital requirements for Goldman and all other big banks. If they have more capital, they are more able to absorb losses ? this would make both their equity and their debt safer.

Professor Admati was also at the same INET conference session (her video is on the same page) and made the case that Basel III does not go far enough in terms of requiring financial institutions to have more capital.

Claudio Borio from the Bank for International Settlements argued strongly that requiring countercyclical capital buffers that would go up in good time and down in bad times could help stabilize financial systems. But when pressed by Admati on the numbers, he fell back on defending the current plans, which look likely to raise capital requirements to no more than 10 percent tier one capital (a measure of banks equity and other loss-absorbing liabilities relative to risk-weighted assets).

Given that US financial institutions lost 7 percent of risk-weighted assets during this cycle and next time could be even worse the Basel III numbers are in no way reassuring. Tier one capital at the level proposed by Basel III is simply not sufficient.

Even among smart and dedicated public servants, there is a disconcerting tendency to believe bankers when the latter claim that equity is expensive  meaning that higher capital requirements would have a significant negative social cost, like lowering growth.

But the industry’s work on this topic produced by the Institute of International Finance last summer has been completely debunked by the Admati team.

Intellectually speaking, the bankers have no clothes. Unfortunately, the officials in charge of making policy on this issue are still unwilling to think through the implications; capital requirements need to be much higher.

For more on the discussion at this INET session, see this page.

An edited version of this material appeared this morning on the’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.