Winding down

March 16, 2010

Regulators need to approach the notion of resolution with resolve. To avoid the next financial mega-collapse, like Lehman or American International Group, Senator Chris Dodd’s new bill for reforming U.S. financial regulation gives watchdogs powers to liquidate all big financial firms, not just banks. This resolution authority should be useful – if regulators aren’t tempted to keep firms afloat instead.

Few disagree with the idea that regulators need power to wind down big financial players, even if they aren’t banks. This was never more clear than in September 2008. Whereas the collapse of Lehman and AIG brought the specter of financial Armageddon, a failing Washington Mutual was seized by the Federal Deposit Insurance Corp and its assets handed off to JPMorgan with relative ease.

The difference was that WaMu was a bank and FDIC had the regulatory muscle to impose an orderly resolution, forcing shareholders and creditors to take losses so as to right-size the balance sheet. Regulators had no such powers when it came to Lehman or AIG.

The Dodd bill would give FDIC those powers. Among other things, it would also require systemically-risky financial firms to submit “funeral plans” — known as “living wills” in the UK — to serve as a roadmap in the event they needed to be shut down.

So far, so good. But Dodd’s plans still aren’t ideal. A proposed $50 billion bailout fund, albeit financed up-front by a levy on financial firms themselves, could create a morally hazardous expectation of bailouts. And skeptics won’t like the fact that the bill contemplates FDIC borrowing from Treasury, even if only for “working capital” purposes.

Where the institution in question is a bank, Dodd’s proposals also allow the FDIC to guarantee debt to avoid a creditor run. The guarantee program enacted during the recent crisis was justified as an emergency measure to prevent wider financial calamity. But if made permanently available, even in the limited circumstances envisioned, there could be a temptation to use it. Seizing the next gigantic failure before it’s too late will take significant courage; regulators shouldn’t have excuses to put the decision off.


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One of the best things they did when creating the FDIC back in ’33 was to make it independent of government funding. This gave the FDIC incentive to break up failing banks early, before the regulated entity made more risky bets and destroyed value further (fine, the incentive was always fuzzy, but it was clearer during the early years than it is today). Once it’s clear the FDIC is backstopped the ability of the insurer to maximize estate value declines as it too becomes subject to moral hazard. Allowing the FDIC to borrow from Treasury is a bad idea. In fact, if you want a stable system, deposit insurance really has to be provided by an isolated institution that won’t be bailed out. Dodd is not solving the problem. He is playing a shell game. Congress has to commit to financial institution failure and dealing with the consequences independent of the failed entity, i.e. fiscal stimulus. If it can’t fail, it should be public and should not be for-profit. Until that happens the system will transfer wealth from the general public to financiers.


Posted by arthurks1 | Report as abusive

[…] Winding down Rolfe Winkler […]

Posted by Links 3/17/10 « naked capitalism | Report as abusive

Regulation that precludes bailouts of bank holding companies seems to make the most sense.

Posted by pwm76 | Report as abusive