Putting insolvent banks back on their feet

By Felix Salmon
September 24, 2009
testimony today, talks at some length about the necessity that the government has a new form of resolution authority:

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Paul Volcker, in his testimony today, talks at some length about the necessity that the government has a new form of resolution authority:

I also believe an approach proposed by the Administration and others should be supported. The basic concept is to provide a new “resolution regime” for insolvent or failing non-bank institutions of potential systemic importance.

The problem here is the “non-bank” part of Volcker’s proposal. Since he explicitly excludes “banking and insurance organizations already subject to substantial official regulation”, it’s not obvious how many companies would be covered by this proposal — GE? Citadel? One or two others, tops?

The real question, which Volcker ducks in his testimony, is the government’s willingness and ability to use its existing regulatory powers to force some kind of debt-for-equity conversion at banks. You can’t use the bankruptcy regime for this, because banks can’t declare bankruptcy without failing: as Jesse Eisinger pointed out to me in an IM conversation, bankruptcy is cashflow positive for most companies, but it’s cashflow negative for a bank.

It would have been great if the government could simply have forced some kind of debt-for-equity conversion at Citi and Lehman and AIG, perhaps combined with some kind of governmental liquidity support. Yes, there would have been a nasty ding to the credit markets, especially since many bondholders aren’t allowed to hold equity. But the financial system would have been put on a much more sustainable footing going forwards, and the choas of Lehman’s bankruptcy might well have been avoided.

So yes, I’m all in favor of a new resolution regime. But let’s get serious about applying it to banks before worrying about whether we should apply it to a handful of systemically-important non-banks as well.

(Related: John Gapper on the Volcker testimony. Recommended.)

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