JP Morgan Chase 2010 Annual Report Download - page 28

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WhentheFDICtakesoverabank,ithasfull
authority to fire the management and Board
of Directors and wipe out equity and unse-
cured debt – in a way that does not damage
the economy. Controlled failure of large
financial institutions should work the same
way. It is complex because these companies
are big and global and require international
coordination.However,iftheprocessiscare-
fullyconstructed(andcompletelyapolitical),
controlled failure can be achieved.
In the process, the role of preferred equity
and unsecured debt needs to be clarified.
This may require corresponding accounting
changes. My preference would be, at the
point of failure, to convert preferred equity
and unsecured debt to pure, new common
equity.Forexample:WhenLehmanwent
bankrupt, it had $26 billion of equity and
$128 billion of unsecured debt. If, on the day
of bankruptcy, the regulators had converted
that unsecured debt to equity, Lehman would
have been massively overcapitalized and
possibly able to secure funding to continue
its operations and meet its obligations. The
process to sell or liquidate the company
would have been far more orderly. And the
eect on the global economy would have
been less damaging.
Payouts received on liquidation of the assets
of the company would have been paid first
tothe“new”equityholdersbeforepayment
wasmadetothe“old”commonequity
holders – this essentially is what happens
in bankruptcy (and would eliminate the
needforcontingentconvertiblesecurities).
It is unlikely that this orderly liquidation
would have resulted in losses exceeding the
$150billionof“new”equity.Therefore,it
would not have cost the FDIC any money.
However,evenintheunlikelyeventofaloss
to the FDIC, we believe that the loss should
be charged back to the banks, not to the
taxpayers, just as the FDIC does today.
Banks should pay for the failure of banks (as the
FDIC is structured today), which is far better than
arbitrary, punitive or excessive taxes
Systemically important financial institutions
(SIFI),notthetaxpayers,shouldpaythecost
of resolving their fellow large institutions’ fail-
ures. This is not a new idea – banks already
bear this responsibility (through the cost of
FDICdepositinsurance).Contrarytowhat
some folks may believe, the FDIC is a govern-
mentprogram,buttheU.S.governmentdoes
not pay for it – 100% of the cost for the FDIC
ispaidforbyU.S.banks.(JPMorganChase’s
share alone of the FDIC’s costs relating to the
crisiswillexceed$6billion.)
Charging banks additional costs – propor-
tionally and fairly allocated – for main-
taining the banking system seems to be both
proper and just. In our opinion, this is far
more preferable than trying to create addi-
tional taxes to SIFIs, as some countries are
discussing. Banks should pay for the failure
of banks but not through arbitrary, punitive
or excessive taxes.
Critical accounting and capital rules need to be
redesigned to ensure better transparency and
less pro-cyclicality
If properly designed, countercyclical
accounting and capital rules can serve as stabi-
lizers in a turbulent economy. I will mention
two issues that underscore the need for this
approach, although there are many more.
First, loan loss reserving currently is highly
pro-cyclical:Whenlossesareattheirlowest
point, so are loan loss reserves and vice versa.
There are many ways to fix this intelligently
while adhering to rational accounting rules.
Second, capital rules even under Basel III
require less capital in benign markets than in
turbulent times. So at precisely the time when
things can only get worse, we require the least
amount of capital. This also is easy to fix.
And one additional observation from outside
our industry: Federal, state and local govern-
ments need to change their accounting stan-
dards(ascorporationsdiddecadesago)to
reflect obligations made today that don’t come
due for many years. This one accounting issue
allows governments to take on commitments
today but not recognize them on financial
statements as obligations or liabilities.