Resolution Authority is Not a Bailout

Edouard Manet, "The Execution of Maximilian"

I did a brief piece for AOL News’ opinion section explaining why “resolution authority” is important, and not a bailout:

[Deposit insurance] prevents bank runs, helps the economy and minimizes moral hazard. It does cost some money, but the funds are raised through fees on the insured banks. The problem is that the laws creating this system are more than 70 years old, and, in the intervening decades, a “shadow banking system” of banklike activities arose outside the FDIC umbrella.

Its participants wanted to evade regulatory scrutiny, so they simply promised that they’d never find themselves asking for bailouts. But when troubles arose, it turned out shadow banks were as vulnerable to runs as real banks.

And if runs had been allowed to happen, it would have spelled big trouble — and not just for banks. A large company can’t park its cash in the same kind of checking account you or I might use, and most of those kinds of funds are tied in to shadow banking. Runs would have made it hard to meet payroll or other basic financial obligations, shutting the economy down. And the only way to prevent runs was through quick-and-dirty bailouts — gifts of cash with the implicit promise of more gifts.

The key to Obama’s regulatory reform proposals is to do away with this system and give the government “resolution authority” over all forms of modern-day financial institutions.

This is not a bailout. It’s more like an organized execution — management will be sacked, owners will lose their money — but it will still cost money to carry out, money that will be gained through fees on banks.

There’s more to regulatory reform than just resolution authority—ideally you actually want to prevent banking crises, not merely mop them up. But if you want to end bailouts, this is the key measure. The alternative of just promising really hard that there won’t be bailouts will, paradoxically, only make bailouts certain to occur.