Posted by: Jeff | May 4, 2010

FinReg: Resolution Authority

There are four major parts to the financial regulation bill Chris Dodd is spear-heading in the Senate: resolution authority, the Financial Stability Oversight Council (FSOC), the Consumer Financial Products Bureau (CFPB), and derivatives regulation. Today I’ll focus on resolution authority. (And as I’ve said before, I really don’t understand a lot of this stuff. So these FinReg posts are as much for the sake of organizing my own thoughts as they are for the edification of our readers.)

Last week I did my best to tell my version of what happened in the financial crisis. And the first thing to say about resolution authority is that it deals solely with Step 5 in my story. Resolution authority is what you turn to once the collapse of a financial institution, which poses major risk to the whole financial system, is upon you.

To back up for a moment, the banking industry has changed dramatically in the last few decades. While still undertaking all the classic functions we’re familiar with – accounts, fees, loans, etc – banks have also gotten into the far more complex world of financial trading, including the derivatives market. In some cases, our government has made conscientious choices to deregulate portions of this system, and in other cases regulation has simply failed to keep up with developments in the industry. In either case, when the crisis hit in 2008 not just the financial system as a whole, but major individual banks, were covered by a patchwork of regulations and jurisdictions, interspersed with large patches of no regulation at all. To a real extent (as I understand it) no one in the government quite knew what their powers and options were. There was no structure in place for dealing with this kind of contingency, and the new kind of entity major banks and financial institutions had become.

So what we got was a make-it-up-as-we-go-along approach. (The Federal Reserve literally had 72 hours warning before Bear Stearns went down.) The government and the Fed bailed out Bear Stearns, then it let Lehman Brothers fail, and then when everything really went to shit they threw the $700 billion TARP fund at the problem. The point of resolution authority is to make sure that doesn’t happen again; it lays down a rules-based structure the FDIC can follow the next time (and rest assured, there will be a next time) a major financial institution threatens to collapse.

If the oversight council in conjunction with the Federal Reserve determine (I’m not sure about the details of the process) that a firm represents a systemic risk, the FDIC can use resolution authority to dismantle it in an orderly fashion that prevents the financial contagion from spreading to the rest of the system – management gets fired, and shareholders and unsecured creditors bear the appropriate losses. (I’m trying to figure out the difference between a secured and an unsecured creditor, and frankly I haven’t quite got it yet.)

You can get a more detailed overview of resolution authority and the financial regulation bill as a whole from this Ezra Klein post. I’d also recommend the April 30 podcast from The Economist, entitled “Financial Regulation Reform,” and the April 30 episode of The Breakdown on whether or no the financial regulation bill is a “bailout bill.”

The important thing to emphasize right now is that resolution authority is the effective execution of a firm. The paradox of a financial crisis is that if you go with a bailout, you protect the financial system as a whole but you introduce moral hazard by protecting the people responsible from the consequences of their actions. On the other hand, if you don’t bail them out the collateral damage to the rest of the financial system can be severe. (Everyone seems to agree in hindsight that the decision to not bailout Lehman Brothers was a terrible one, and probably went a long way towards precipitating the rest of the crisis.) Resolution authority attempts to resolve that paradox; it both provides protection for the rest of the financial system, and inflicts consequences on the people in charge of the offending firm.

However, the execution itself still costs money, which is where the liquidation fund comes in. This is a $50 billion dollar fund that is raised by taxing the largest banks, and whose purpose is to be available for paying the various costs of winding a failing firm down should the need arise. Whether or not it will be in the final bill at all seems to be open question; both the White House and the Republicans have been inclined to kill it, and Economics of Contempt thinks they’re doing Wall Street’s bidding on that front.

Even if the liquidation fund dies, however, that would simply be the “pre-funded” incarnation of it. A “post-funded” version would still exist, since the costs still have to be taken care of somehow. There seem to be good arguments for either approach:

With a pre-funded resolution fund, you lose the ability to tailor financial institutions’ respective contributions to the fund based on how much they benefited from the resolution of a large bank, or how culpable they were in causing the bank to fail. For instance, with a post-funded resolution fund, we could make JP Morgan and Citi pay for a larger share of the cost of Lehman’s failure, based on the conclusions in the Examiner’s Report. Pre-funding obviously forces the banks to internalize the costs upfront, but it sacrifices the ability to tailor the costs of a bank failure.

And that’s about it. I’ll try to get to the criticisms and disagreements over resolution authority next.

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Responses

  1. Jeff, one of the concerns Republicans have with the financial regulation bill is the burden it could place on small businesses and community banks. This video illustrates this:

    Sean Hackbarth
    Senate Republican Conference

  2. Sean, thanks for the video. I’ve tried to emphasize in my posts on FinReg that I’m hanging on by my fingernails knowledge-wise. Within the scope of what I understand, some of the Republicans’ objections have struck me as rather silly, but others seem to have real teeth. I originally wanted to deal with those disagreements in this post, but it was turning into a monster as it was.

    As to the video itself; it’s rather vague. Clearly the speakers are concerned that the FinReg bill will hurt smaller businesses and banks, but they don’t really explain how they think that will happen. From what I can deduce, their objections aren’t really about resolution authority but rather the effects of the CFPB, and perhaps to a lesser extent the effects of derivatives regulation.


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