Greenspan's Call for Bail-Ins

More

Yesterday, when former Fed Chair Alan Greenspan testified (.pdf) before the Financial Crisis Inquiry Commission, much of the hearing was focused on accusation and causation, with far less emphasis on solutions. Earlier today, Atlantic Correspondent Ben Heineman Jr. pointed this out, and highlighted the former central banker's call for regulatory reform. In doing so, he mentioned some of Greenspan's ideas. One, in particular, could mark a promising step towards solving the too big to fail problem.

The idea of a resolution authority sounds great in theory. A regulator that can neatly and quickly wind down a large financial institution would definitely have helped a few years ago. But on a practical level there's some fear that if only select firms are subject to the resolution authority, it could provide a competitive advantage. There's also some question of what liquidation costs would be covered through a resolution fund, as creditors would lend more cheaply to a firm if they know some of their investment is guaranteed even if an institution fails.

And that's where Greenspan's idea comes in. It roughly follows the bail-in theory described here, where large troubled institutions could convert debt to equity in order improve their capital levels, without needing to be wound down. The problem, of course, is that a resolution authority can't do this haphazardly, or the market would just have even more uncertainty. You can't leave such details up to the whims of regulators. Greenspan's solution: detail how this conversion would work. In his prepared testimony, he said:

The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large "moral hazard" that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds--that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.

However, should contingent capital bonds prove insufficient, we should allow large institutions to fail, and if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility. That would grant the regulator access to taxpayer funds for "debtor-in-possession financing." A new statute would create a panel of judges who specialize in finance. The statute would require creditors (when equity is wholly wiped out) to be subject to statutorily defined principles of discounts from par ("haircuts") before the financial intermediary was restructured. The firm would then be required to split up into separate units, none of which should be of a size that is too big to fail.

Greenspan's point about moral hazard is very important. The big worry is that if large institutions will be rescued, then their creditors will provide them cheaper debt. But if investors' bonds will be converted to equity at some relatively unfavorable conversion rate, then suddenly creditors won't be as willing to provide big firms a significant funding advantage. Indeed, the idea of paying more for debt might even discourage firms from growing so large in the first place. The key would be to force most or all debt of systemically relevant firms to be subject to equity conversion when some pre-determined capital inadequacy trigger has been hit.

He further calls for firms to fail if the conversion won't restore capital to a sufficient level. This would make the possibility of rescuing a firm through debt-to-equity conversion a sort of "Chapter 11" bankruptcy mechanism. Firms that can't be saved even through this means would be resolved. That would be closer to traditional "Chapter 7" liquidation. This would allow firms that aren't sick enough to require wind down to have a sort of managed bankruptcy reorganization through debt-to-equity conversion.

The only area where Greenspan might lose some public support is his thought that taxpayer funds should be used for debt-in-possession financing. But that could be easily fixed through the creation of a resolution fund through assessments on large institutions, as the regulation measures in Congress already call for.

Other than that, Greenspan's idea would be a welcome addition to the resolution authority. It would eliminate a great deal of uncertainty regarding failure scenarios of giant firms, but also require their failure if that's the best option.

Jump to comments
Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
Get Today's Top Stories in Your Inbox (preview)

Is Technology Shifting Our Moral Compass?

"The experience of taking another human life becomes much more trivial."


Elsewhere on the web

Join the Discussion

After you comment, click Post. If you’re not already logged in you will be asked to log in or register. blog comments powered by Disqus

Video

Juice Cleanses: The Worst Diet

A doctor tries the ever-popular Master Cleanse. Sort of.

Video

Why Did I Study Physics?

Using hand-drawn cartoons to explain an academic passion

Video

What If Emoji Lived Among Us?

A whimsical ad imagines what life would be like if emoji were real.

Video

Living Alone on a Sailboat

"If you think I'm a dirtbag, then you don't understand the lifestyle."

Feature

The Future of Iced Coffee

Are artisan businesses like Blue Bottle doomed to fail when they go mainstream?

Writers

Up
Down

More in Business

Just In