Too Big To Fail, Part VII: Resolution Authority

I'm nearly done tackling the financial stability regulation (.pdf) proposed this week by the House Financial Services Committee. Earlier, I wrote about the securitization provision. Yesterday, I covered a variety of topics as well (links at the bottom of this post). This might be my favorite part: the resolution authority. I've been calling for a non-bank financial firm resolution authority for months. I'm shocked to report that Congress didn't do too badly with this plan. Let's dig in.

The "Resolution Authority for Large, Interconnected Financial Companies Act of 2009" is almost 90 pages. Clearly, I can't cover all that in one post. So instead, I'll do my best to point out some highlights. A lot of the content consists of technical descriptions of how the logistics of resolution process will actually work, which generally isn't of much interest anyway.

This Act seeks to give the Executive Branch the authority to bring about involuntary resolution of non-bank financial firms. Essentially, the Federal Reserve and sometimes other regulators will recommend to the Treasury Secretary that a firm whose failure could threaten financial stability should be resolved. The Treasury Secretary then talks it over with the President and decides whether the firm should be seized.

So what type of firm might find itself in that pickle? One in danger of default. Here are the criteria the doc lays out.

The company:
- has or is about to enter bankruptcy
- is "critically" undercapitalized (see my capital explanation)
- has incurred or is about to incur losses that will deplete all its capital
- has or will have fewer assets than credit obligations
- can't pay its obligations

Next, the Federal Deposit Insurance Corporation takes over. Then, it does its thing as resolution authority, similar to what it does for depository institutions that hit the wall. That includes getting rid of the firm's management. Contracts can be broken, shareholders wiped out, etc. Here's some of what it will do during the resolution process to stabilize the situation:

- Make loans; purchase debt
- Purchase assets
- Guarantee obligations
- Acquire equity interest or securities
- Take liens on assets
- Sell or transfer assets

The draft specifically says that the government will only take such actions to resolve a firm if financial stability is threatened. For example, that probably means a finance company whose failure doesn't pose systemic risk -- like GMAC -- wouldn't be resolved by the government. They'd just let such firms go bankrupt the good old fashioned way.

Clearly, such a process will not be without winners and losers. One thing that this plan appears to take exceeding care to ensure is that taxpayers won't be left with the bill. Here's the priority for unsecured claims:

- Administrative expenses of the receiver (usually FDIC)
- Amounts owed to the U.S.
- Senior Creditors
- Shareholders, partners, etc.

This seems reasonable enough. But what if there isn't enough money left over after all assets are sold to cover all of the U.S.'s expenses? Then it gets interesting. If the proceeds from asset sales are:

insufficient to repay the amount of the stabilization action in full, the difference shall be recouped through assessments on financial companies

Here's the thing: I get that Congress doesn't want taxpayers to be stuck with the bill; I don't want that either. But I'm not particularly convinced that the rest of the industry should pay for the failure of other firms. For example, should Wells Fargo have been forced to pay part of the cost of Lehman failing? I don't see why it should have.

So what could be done instead? As mentioned in my post on the proposal's heightened regulatory requirements, firms must provide a resolution plan, which presumably will be followed if the worst case happens. I'm not sure why that plan wouldn't also include scenarios that would estimate what resolution might cost. While such scenarios might not be perfect, I think you could devise stress scenarios to get pretty close. Then you could back into a number that the government might be on the hook for, assuming that shareholders and creditors both get nothing. Why not instead, proactively require all firms that pose systemic risk to fund a sort of capital reserve account for that amount?

Each time the firm reconfigures its failure plan, as its risk changes, so could the amount in that reserve account. I find it hard to believe that some reasonable amount couldn't be required for such accounts to ensure that the government isn't on the hook. I think it is preferable that firms pay for their own resolution, rather than the rest of the industry paying for the bad eggs.

All in all, it doesn't seem that the purpose of this resolution authority is to bail out firms. Dissolving firms really seems like its only objective. The way it's written, I don't see much room for firms to exist as a stand alone entity again after the FDIC takes them over. That's extremely good.

I also like that the FDIC is in charge, as its responsibilities regarding depository institutions already include this kind of action. It also spreads the power out better, which thus far has been concentrated pretty heavily on the Treasury and Fed. My only real disappointment in this process is how it intends to pay for resolution after shareholders and creditors are wiped out.

Prior posts on this draft:

Oversight Council
Determining Systemically Risky Firms
Heightened Regulation
Capital Requirements
Emergency Stabilization