Huntsman and the GOP Debate on Unwinding Too Big To Fail

James Pethokoukis at AEI: Jon Huntsman declares war on big banks and Too Big To Fail.

There are a series of proposals, mostly surrounding taxes and caps on size, leverage and complexity.  The first bullet point, a cap on size relative to GDP, is similar to the SAFE Banking Act, which failed in the 2010 Senate with 33 votes.  They all sound like good ideas, though they received little-to-no GOP support during the Dodd-Frank debates.  I hope the GOP moves more in this direction generally.

But there’s a core missing in it.  When it comes to “ending Too Big To Fail” it actually punts on the conservative policy debates, which is a shame.  There’s a reference to “Explore reforms now being considered by the U.K. to make the unwinding of its biggest banks less risky for the broader economy” but it is sort of late in the game for this level of vagueness on what we mean by “unwinding.”  That unwinding part is a major part of the debate.  Especially if you say that you want to repeal Dodd-Frank and put into place a system for taking down large financial firms – well, “unwinding” the biggest financial firms is what a big chunk of Dodd-Frank does.

(As Yglesias noted previously on Hunstman and TBTF: “The first [idea] is to repeal Dodd-Frank’s proposed mechanism for resolution of large banks. The second is to do what Dodd-Frank’s proposed mechanism for resolution of large banks does.”)

So any attack on Dodd-Frank from someone who wants to be the financial reform leader needs to address some hard questions when it comes to the big banks, particularly how their unwinding solutions and policy will be superior to Dodd-Frank.  Luckily there’s already an active debate on the Right on this topic.  Here are the major high-level ideological policy debates, as I see them, on the Right when it comes to dealing with Too Big To Fail:

1.  Courts or FDIC?  The big one for conservatives:  Should a failing Too Big To Fail financial firm go through a bankruptcy court, or should it go through a special “resolution authority” like what FDIC does to regular banks?

Dodd-Frank created a special resolution authority.  In fact FDIC recently released a paper explaining how it would have taken down Lehman Brothers (our coverage).  Conservative scholars thought this was an invitation to bailouts and that the FDIC was in over its head – here’s FDIC forcibly responding on this to a set of arguments from AEI during Dodd-Frank.

Meanwhile some conservative scholars have been arguing that changes to bankruptcy code would be sufficient, and that the additional regulations that come with resolution authority are unnecssary – here’s a blueprint for “Chapter 14” bankruptcy from the Hoover Institution.  Changes to bankruptcy usually imply no regulations on the financial firms themselves are necessary.

2.  Bailouts forever?  Does “resolution authority” as currently constructed have “bailout” mechanisms, or things that could be construed as bailout mechanisms?

Depending on who is talking, this usually refers to either the FDIC’s ability to provide “an immediate source of liquidity for an orderly liquidation, which allows
continuation of essential functions and maintains asset values” or its ability to repay creditors.  For the second, see Nicole Gelinas or Phillip Swagel.  To my mind, the bill requires that the FDIC quite clearly “‘not for the purpose of preserving the covered financial company’; ensure that shareholders are paid only after all other claims are paid; require that unsecured creditors bear losses; and terminate ‘management responsible for the failed condition.'”

It’s very easy for the GOP to say that Dodd-Frank is a “bailout bill”, but they should be pressed for exactly what they mean when they say that and how their approach would be different, especially if they’ll have a resolution mechanism.

3.  How to Trigger a Collapse?  Specifically, for those in favor of resolution, do we rely on regulators and “Prompt Corrective Action” or market-signals through credit default markets to start unwinding?

Here’s Economics of Contempt defending PCA in the Dodd-Frank bill and here’s Oliver Hart and Luigi Zingales on CDS prices.  Zingales noted that this would require derivative regulation beyond the pre-Dodd Frank status quo, something that conservatives would have to sign onto (or explain why it isn’t necessary).  But there are some practical problems to those U.K. solutions that Huntsman refers to, things currently being debated.

4.  Convertible Debt? Do we require that large systemically risky financial firms issue “CoCo” bonds, or other financially engineered debt that turns into equity during a crisis, to help with the unwinding problem?

This has been a favorite for many conservatives including Paul Ryan, Chris Papagianis of e21 the AEI Shadow Banking committee, and Charles Calomiris.

Currently, this is going to be studied in Dodd-Frank and then the FRB can choose to enact it: “Following a two-year study on the subject of contingent capital, the FRB may issue regulations that require systemically significant non-bank financial companies and bank holding companies with more than $50 billion…”

The banks would hate it.  They’d have to pay a premium to do this, so you’d need the government to really want to pull it off, as the banks would lobby hard.

Also it would require strong regulation through and through.  Raj Date wrote a great critique of this proposal back during Dodd-Frank, pointing out without strong regulations it would function like preferred stock (or in other words, not well).  So follow-through is important – this isn’t a sit-back-and-relax type of regulation.

I’m looking forward to seeing how Huntsman, whose presence in the debates I’ve enjoyed so far, and other members of the GOP deal with these complexities.