BCCI: A Lesson on the Dangers of 'Too Big To Fail'

HARDLY anyone believes the failure of the shadowy Bank of Credit and Commerce International was a good thing. After all, BCCI had offices in 69 countries, assets of more than $20 billion, and hundreds of thousands of depositors.No one knows what the price tag for the bank's closure will eventually be. However, knowledgeable insiders are betting that the losses will total at least $5 billion and might go as high as $15 billion. Yet in the long view of history, the BCCI affair may prove to be a blessing in disguise, a watershed event in international finance that could clear the way for a much sounder banking system in the years ahead. As a bank, BCCI was shot full of self-dealing and fraud, a haven for drug money and a vehicle for extralegal international arms transactions. While fresh details concerning BCCI's operations have poured out since the bank was shut down, the gist of the story has been public for years. Banking agencies put financial markets on notice that BCCI was rotten with a series of judicious leaks about its questionable dealings. The association of former Secretary of Defense Clark Clifford with First American Bankshares, which the Federal Reserve has long contended is one of BCCI's United States holdings, has long been a cause celebre in Washington. (First American's subsidiaries were not included in the BCCI shutdown.) Despite such ample notice, market players continued to do business with BCCI's many affiliates, presumably on the ground that the bank was simply "too big to fail," even though the deposits were not legally insured. In the end, financial institutions had billions in deposits and trading contracts outstanding with BCCI when the authorities swooped down on July 5. Hopefully, the financial pain and suffering that will follow in the wake of the BCCI failure will provide a definitive object lesson for the banking community. Big banks, as well as little banks, can go down the tubes. When they do, somebody will lose money. If this statement seems self evident, rest assured that it is not. Starting with the failure of Franklin National Bank in 1974 (then the 20th largest bank in the US), regulators in the US and overseas lulled market participants into believing that some banks are "too big to fail." While big depositors of small banks sometimes lose money, big depositors of big banks are safe. "Too big to fail" is, in fact, a key issue in the debate over the basic overhaul of US banking rules now pending in Congress. In its massive study of financial reform, the Bush administration recognized that "overextended deposit insurance has ... removed market discipline that should have constrained the increased riskiness of weak banks." The study added: "Depositors should have shifted funds away from unprofitable, undercapitalized, and risky banks, forcing them to shrink or decrease risk. But with expanded federal insurance and no risk of loss, depositors have been more than willing to supply funds to weaker banks engaged in activities that produce inadequate returns and excessive risk." The administration focused its analysis, naturally enough, on the domestic banking system. Even so, these conclusions apply equally well to BCCI and large multinational banks. If regulators had not convinced depositors and creditors of BCCI that somehow they would be protected against loss, the bank could never have grown to the size that it did. The study asked the right question. However, the administration was too timid to follow its own logic. "In a given case," the study said, "the presence of systemic risk could require a decision to protect uninsured depositors." This hybrid strategy will not get at the underlying problem. It uses market discipline to keep wayward bankers in check only so long as this is convenient. The BCCI affair made clear that this approach was too cautious. If the Treasury's fears had been justified, world financial markets might have been damaged. They were not. Participants in world financial markets must know that they will lose money if a bank fails. That is the only way to protect the financial system from the misdeeds of an individual banker. Reform of deposit insurance must include a quick and decent burial for "too big to fail." If the collapse of BCCI finally disabuses participants in world financial markets of that pernicious notion, it will be well worth every penny it costs.