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.