Improving the Administration’s Too Big to Fail Approach

Economics of Contempt has an excellent post up noting that the Obama administration’s proposed regulatory reforms actually do quite a bit more to deal with the “too big to fail” problem than is generally acknowledged. In particular, along with various regulatory steps, they’re asking for specific “resolution authority” over so-called “Tier-1 Financial Holding Companies. This would create a non-bankruptcy approach to dealing with insolvent big financial firms, much as the FDIC process exists for conventional banks.

But he also notes a substantial flaw in the proposal:

I think the administration makes a big mistake by requiring a separate “systemic risk” determination in order to use the proposed resolution authority for Tier 1 FHCs. This introduces needless uncertainty. Remember, a financial company is a Tier 1 FHC, by definition, if “material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress.” An institution thus can’t even be a Tier 1 FHC in the first place if it doesn’t pose a systemic risk. Why require an additional, albeit slightly different, determination of “systemic risk” before the new resolution authority can be used? This will leave the market guessing as to which resolution regime — the Bankruptcy Code or the new resolution authority? — will be used to resolve a distressed Tier 1 FHC. Creditors, unsure which resolution regime will apply and thus how their claims will be treated, will be less likely extend credit at exactly the time we don’t want creditors to be pulling back from a Tier 1 FHC.

I would make the new resolution regime automatically applicable to Tier 1 FHCs. By requiring a second “systemic risk” determination, the administration is essentially saying that there are Tier 1 FHCs that can be resolved in an orderly fashion under the Bankruptcy Code as it’s currently written. You’d be hard-pressed to find any market participant who agrees with that statement (in fact, I don’t believe Tim Geithner honestly believes that statement). I continue to be confused by the insistence on a second “systemic risk” determination.

I think the real problem here isn’t that there’ll be uncertainty about whether or not the Bankruptcy Code will be used. The problem is that given policymakers clearly indicated (and correctly so) unwillingness to resolve big financial firms through bankruptcy, this seems to continue to hold the door open to future bailouts rather than actual use of the new resolution authority.

Either way, the proposal could be greatly improved by making this more automatic.