Some Arguments on Resolution Authority

I wrote about how to think of resolution authority as a series of practices rather than an on-off switch. A few points are being made around the blogosphere about resolution authority, and I’d like to address them.

Information

Ezra Klein likes this language:

Funeral Plans: Requires large, complex companies to periodically submit plans for their rapid and orderly shutdown should the company go under. Companies will be hit with higher capital requirements and restrictions on growth and activity, as well as divestment, if they fail to submit acceptable plans. Plans will help regulators understand the structure of the companies they oversee and serve as a roadmap for shutting them down if the company fails. Significant costs for failing to produce a credible plan create incentives for firms to rationalize structures or operations that cannot be unwound easily.

I do not. Notice how this strategy would look for FDA if we were creating the FDA now: “Drug companies will be required to submit the effects of their drugs that they market from internal studies that they’ve carried out. That is all.”

There’s an obvious agency problem: if you are a large, complex company and you’ve failed, you want the regulators to be as confused, scared, and uninformed as possible so they will bail you out. It’s worked before. What’s the penalty for a failed firm that doesn’t do this well? They are already failed. If you are less cynical about the financial markets than I am, it’s still costly, time consuming and kind of a pain in the ass to collect this information well, so you will probably half-ass it.

This is crucial for the “detection” part above. For detection to be credible, the information will have to be global, with deep knowledge of interconnectedness, especially when it comes to derivatives. All the focus is on repo 105, but people who are interested should check out Portnoy’s writeup of how the Federal Reserve monitored the books at Lehman after the SEC called them in to help. They had no clue how to do detection of problems in financial firms.

So if you want to support the Dodd Bill, one obvious way to increase the effectiveness of it would be to significantly beef up both the scale and scope of information that is collected on a large, complex financial company. Firms will fight this tooth and nail, of course.

Since we have no political will to shrink the size of the largest banks, even gradually, being able to monitor them to know whether or not they are failing so we can take appropriate actions beforehand is crucial. Commercial banks have to be resolved in a “least-cost” manner, the least-cost to the taxpayers. Financial firms, under early remediation requirements, will have the same mechanism. But to do that we need tools to monitor large banks, and we are going to be going into that process with the tools we use to monitor the George Bailey Bank.

Funding

Matt Yglesias writes about resolution authority:

And since dealing with an insolvent firm without bankruptcy isn’t going to be free, we set up a mechanism to raise the funds necessary from the institutions who are being given this protection from bankruptcy.

This is the $50 billion dollar fund.

I asked Rolfe Winkler, who blogs Bank Failure Fridays, and he told me, excluding WaMu (and the last two weeks, since he hadn’t updated the numbers), the Deposit Insurance Fund, the fund FDIC uses with money raised by banks, takes a hit on average of 23% of assets whenever it resolves a commercial bank, a George Bailey Bank.

So for a bank with $2 trillion dollars in assets, your Bank of America or JP Morgan, that’s $460 billion dollars. And the top six banks are much bigger than they were before the crisis, and everyone should believe they will continue to grow into the future. And this is a single failure, not a crisis of all the biggest firms getting into trouble together, as they most certainly will.

And that’s the George Bailey bank. We know how to do that well. Our detection methods are much better than in this new uncharted territory. Now we don’t have a scope of guarantees, which makes me wonder what exactly this fund will be used for. Maybe resolution authority will be handled in a much more cost effective way. I’ll see if I can crunch more numbers later, since Temporary Liquidity Guarantee Program (TLGP) was a strung together sort of version of what this would be trying to do and maybe I can get a sense from there (any other suggestions?), but even in a best case scenario $50 billion seems small. Frank’s bill was $150 billion.

Given that it is in the realm of possibility that it could be exhausted, where does the $51st billion dollars come from for Goldman Sach’s resolution?

Transparency

The meta argument I’m not seeing developed is that there is a conflict between what we’ll want the Federal Reserve to do if we are going to give it the responsibility to monitor large, interconnected financial firms. On one hand, it is essential that regulators are accountable, follow strict rules, serve the interests of the public, and are transparent. These are progressive values, though they are common sense now because we won that debate.

The Federal Reserve ferociously defends its right to be the exact opposite of these values when it comes to monetary policy. How can we then expect it to be a good regulator of the largest financial firms? Given the low level of trust in the Federal Reserve these days, it is essential that resolution authority is transparent as possible. But how will that impact the independence of monetary policy?

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9 Responses to Some Arguments on Resolution Authority

  1. Pingback: FT Alphaville » Further reading

  2. Marchel says:

    How do you think the House’s “resolution authority” compares to Dodd’s “funeral plans”?

  3. Ted says:

    I’m so skeptical of the government’s ability to regulate correctly I think we should consider bringing in the private sector, especially given the thoroughness of the Jenner & Block report. Speaking of which, I think accounting reform needs to be more on the table given that report. I can only wonder what would turn up on Citigroup or BoA’s books if we had a similarly thorough examination.

    Has anyone considered something along these lines. We identify systemic firms. We identify accounting / law / audit firms that we deem “acceptable.” And then we randomize audits of these firms (paid for by a small tax on each firm to cover our costs, which all things equal are more or less the same since they no longer have to pay for audits and reports themselves). The firm doesn’t get to see the report or which firm conducted it till it’s over with (to prevent bribes basically). If the audit reports something fishy, bring out the subpoenas and move from there. I think that could prevent the regulatory capture, the book cooking, and the government incompetence. The firms who did the audits would also be particularly thorough since they wouldn’t want to risk losing their status as an “systemic-auditor approved firm”, both because of the loss in revenue and status. I could see this working for stress testing as well, but I would want to the Fed to be doing that in addition to the private firms just to make sure.

    Maybe some are uncomfortable seeing that type of power handed over to the private sector, but given the complete failure of the SEC and the Fed at this stuff I can’t see how they could possibly do worse. The private sector seems to fail in these issues when the company itself hires accountants and accounting firms. If we removed them from the equation, I think we would get very thorough reports. Obviously the SEC and Fed would still have a strong oversight role and be able to audit any firm they desire in addition to the report by a private auditor.

    • jake chase says:

      Not bad, but all the capable accounting and law firms have conflicts of interest. Of course, you could use the third year class at Harvard Law School and two hundred IRS accountants. They have nothing to do, particularly the accountants.

  4. Adam Hyland says:

    In re: Funeral Plans

    It isn’t even just the agency problems. Outlining and presenting a shutdown plan to a regulator is about as effective as outlining and presenting a data backup plan to your boss. Often it doesn’t work when you need it to. Data backup plans need to be executed, along with recovery. I imagine that any financial firm with a duty to shareholders & customers will be in a bind. Testing the funeral plans would involve small scale unwinding of complex positions (or better, not getting into those positions in the first place) and model based extrapolations of the response. Who decides what customer’s funds get used in the experiment? Who decides how/whether to shut the experiment down should their minor exit prompt a scare in that market?

    Data backup plans work iff they are rigorously tested and utilized. Any other data backup plan will fail in the clutch. I don’t know why funeral plans might be any different.

  5. Pingback: Links 3/20/10 « naked capitalism

  6. Ed says:

    I agree about the funeral plans to the extent that I grasp the underlying problem. It would seem that predicting the dynamics of failure would require determining the cause of failure in advance, and the plans would only be as accurate as the assumption about what caused the failure.

    That said, would such a plan even be followed in an armageddon scenario? It seems unlikely.

    And we are to assume that the $51st billion comes from general revenue out of Congress, just like it did last time around.

  7. engineer27 says:

    I agree that $50 billion is too little. The problem is, any amount is too little if the institutions are allowed to grow unchecked.
    Better to have a funding level that is indexed to the size of the financial services industry as a whole, estimated not by the institutions themselves (they are too adept at making their balance sheets look smaller than they actually are) but by an outside observer.

  8. Pingback: Resolution Funding and Living Wills « Rortybomb

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