The Obama administration’s idea that it should be able to take over any failing financial firm posing systemic risk might not be as sound as almost everyone assumes. Instead of creating less chaos and more stability, it could have a dangerously destabilizing effect on markets.
Almost everyone wants to avoid the chaos they believe was unleashed when Lehman went into bankruptcy, an event which is now widely viewed as a disaster. And establishing a so-called “resolution authority” seems to be the near universally approved solution to this problem.
The idea behind establishing resolution authority makes sense. Properly adminstered, a credible resolution regime could force market participants to realise the full costs of their decisions and help reduce the ‘too big to fail’ dilemma. It sure sounds preferable to the inconsistent reaction of the government to last year’s failures, and is surely better than providing bailouts to failed firms.
But expecting resolution authority to be properly administered may be a bit far fetched. The FDIC is able to carry out a similiar task with respect to bank holding companies because it has bank examiner inside every bank. Will the Treasury Department or the Federal Reserve be able to place an army of inspectors inside every large hedge fund, every big insurance company, and every investment bank?
Perhaps more importantly, the FDIC’s track record isn’t perfect. There seems to be at least some degree of arbitrariness when it comes to which banks get seized and which are permitted to cling to their independence. It seems likely that government officials will have a great deal of discretion when it comes to using resolution authority, which will mean that financial firms will employ lobbyists and appeal to their favourite Senators to prevent themselves from being (in their view) prematurely “resolved.” We’re sure Senators like Chuck Schumer and Chris Dodd will love what resolution authority does to the campaign coffers.
The way the Obama administration envisions the structure of the resolution authority could wind up seriously distorting the market. According to Tim Geithner, resolution authority will apply only to Tier 1 Financial Holding Companies, a limitation meant to reassure the American people that the government is not giving itself the authority to just shut down any company it doesn’t like. But this could have the effect of encouraging companies to game the system–either to become Tier 1 or to avoid it. Think of the way we already see banks gaming reserve requirements.
The market’s reaction to the resolution authority will be unpredictable. The authority will create a new kind of Kremlinology of the Resolution Authority, with traders betting on which firms will be “resolved” much as they now short sell banks that may be seized by the FDIC and trade in advance of anticipated Federal Reserve statements and policies. Having more trading based on bureaucratic decisions is not a healthy path for markets.
The regulation of the financial sector is already so complex that there is no real way of predicting all the consequences of this new resolution authority. It might be better to adopt plans that don’t empower government officials to play a larger role in markets. An accelerated bankruptcy plan might do the trick. Or pehaps the UK’s idea of requiring financial firms to having “living wills”–basically an advance roadmap of what to do in case of failure.
There’s also a very strong possibility that we don’t need to do anything at all. We’re on the record explaining that the government’s decision not to bail out Lehman Brothers and the firm’s subsequent bankruptcy was not a disaster. If the real inspiration for resolution authority is to avoid another Lehman, the motivation for the policy is misguided. We might do better, in fact, of making it clear that Lehman’s failure is the model of what should happen–something that would surely encourage market participants to keep a closer eye on their counter-parties.
Perhaps as the details are worked out, some of these concerns will be addressed. For now, we’re not convinced that the idea of erecting a death panel for important financial firms will do very much to create a more stable financial system.