I like Steve Waldman’s post getting between the arguments of The Epicurean Dealmaker (TED) and Yves Smith over the issue of rules versus discretion in resolution authority. TED: “But I continue to maintain that the law authorizing the resolution authority—as opposed to the confidential working documents, plans, and intentions of the authority itself, which can and should be as specific as possible (and subject, of course, to constant review and revision in response to changing circumstances)—should be drafted at a very high and determinedly vague level.”
I’ve been thinking a lot about this issue lately, so I’ll use this as a prompt to write out some thoughts.
Prompt Corrective Action
This is a high-level discussion, so it might be helpful to lay out specifics on what I think is the most important item for this debate and resolution authority – prompt corrective action. These are quantitative triggers in terms of the bank’s balance sheet that force regulators to act. I’d want the broad outline codified in the law, as they were when it was created. These can be supplemented later, by regulators reacting to situations on the ground. But if a firm trips the first measure of being “undercapitalized” according to PCA, there should be clear written rules related the time available to get out of the situation, and under what conditions it would escalate to the next level. I think TED is with me here.
Economics of Contempt thought that having PCA was essential to Resolution Authority. Here’s one of the creators of PCA, Richard Carnell, writing in the MMBM report about how it can subvert the perverse incentives of regulators:
Banking Statutes Impose Inadequate Accountability
Properly framed statutory standards can heighten regulators’ accountability and counteract perverse incentives. Congress did employ such standards when requiring regulators to take “prompt corrective action” to resolve capital deficiencies at FDIC-insured banks. Such banks face progressively more stringent restrictions and requirements designed to correct problems before they grow large and in any event before they cause losses to the insurance fund. A regulator can accept an undercapitalized bank’s capital restoration plan, and thus permit the bank to grow, only by concluding that the plan “is based on realistic assumptions, and is likely to succeed in restoring the institution’s capital.” If the bank’s capital falls so low that the bank has more than $98 in liabilities for each $100 of assets, the FDIC must take control of the bank unless the regulator and the FDIC agree on an alternative approach that would better protect the FDIC. 12 U.S.C. § 1831o. These standards have teeth. They limit regulatory procrastination and provide clear consequences for capital deficiencies.
I think this is the compromise TED would be in for – there’s discretion with what constitutes realistic plans and expectations of success, but there’s also a clear line when efforts have failed. I want to note two things:
1. There’s a book about treating alcoholism called “I’ll Quit Tomorrow.” I worry that without a clear rule triggering resolution escalation, with too much discretion, we can call the next book “I’ll Resolve You Tomorrow.” The regulator’s incentives are asymmetric – if the problem goes away between now and tomorrow, their job is easier and no powerful and connected campaign donors are going to be mad at them and try to get them fired. If it gets worse, well the taxpayers are ultimately on the line. Setting up rules to supplement discretion takes into account these “behavioral” inclinations of actors, and also start attacking the problems earlier with the taxpayer in mind than later.
2. Everyone knows what Miranda Rights are for people being arrested? “You have the right to remain silent…” There’s a knee-jerk assumption that these rights protect suspects. They do, but they also protect the police officers themselves. As long as they follow the clearly written rules, the discretion they choose to use in questioning is all within bounds. Discretion has no real authoritative power unless it is exercised within the constraints of rules.
PCA gives regulators the same type of cover. If a connected Congressman wants to know why a bank in his district is being told to raise more capital, or is being closed, the regulator can say “my hands are tied.” And they were. Again the regulator had a lot of discretion in-between, but there were clear rules when it was out of his hands. Lots of regulators have said being able to say that and to have it be true has made their jobs significantly easier in the age of massive campaign donations.
The real problems with resolution authority are going to be (a) international, particularly when it comes to information sharing and free-riding and (b) coordination. If we now accept the biggest 6 banks are all systematically risky, they will also all get into trouble at the same time. So there’s an incentive to be the last one approached for painful resolution corrections, since if the first two get resolved/bailedout/whatever, the last 4 will have it much easier on their books. So there’s an incentive to delay as much as possible.