When To Pay For Failure

Now that the House has passed financial reform legislation, the debate will continue heating up. This morning on CNBC, Rep. Paul Ryan (R-WI) and president and CEO of the Securities Industry and Financial Markets Association (SIFMA) Tim Ryan talked about a few aspects that bother them. One was how the new non-bank resolution authority -- which both appear to support, in theory -- collects money for its resolution fund. They both complained that it would be assessing firms fund beforehand, instead of after-the-fact. I find their reasoning pretty weak.

Here's an abbreviated version of their conversation, where I dissected just the parts about the resolution fund:

Tim Ryan: We think the idea of prefunding is probably not the smartest way to do this. We agree with Geithner and Bernanke. It's better to do it after the fact. Post. So you can figure out actually how much you need and you can asses the right fees (people?).

Paul Ryan: Look at TARP right now. You throw money on the table in Washington, it will get spent on something other than its intended purposes, and that's what I worry this resolution fund will end up being.

Let me start with Paul Ryan's complaint. It's actually different from Tim Ryan's worry. Paul Ryan fears that Washington simply won't be able to keep its hands off the resolution fund, and will use it for purposes other than resolution. I think that's completely absurd.

For starters, it's pretty easy to require that the fund only be used for resolution -- just clearly state that in the legislation. But he actually appears to imply that Congress or the Treasury would try to tap into this money. I don't know how that could possibly happen. This fund would be controlled by some regulatory authority -- neither Congress nor the Treasury.

For example, think about the Federal Deposit Insurance Corporation's (FDIC) resolution fund for banks that currently exists. As far as I know, neither Congress nor the Treasury has ever attempted to use that fund for other purposes. I also believe that the FDIC has been pretty good about only using that money for depository insurance for failing banks.

This analogy is especially relevant in the case of the non-bank resolution authority, since the FDIC will be performing that function as well. I'm not sure precisely who is said to have control over the new fund, but it should be the FDIC -- and if that's not the case, then this should be changed. Given its track record, the FDIC has proven it can be trusted with this responsibility, silencing Paul Ryan's compliant.

Tim Ryan's criticism of pre-funding is far more valid, but still misguided. He's right to say that it's impossible to really know precisely how much money the fund should have in order to be effective. Yet, the same could be said about depository insurance, and that's functioned pretty well historically. The fund is running low on funds as a result of the financial crisis, but even now, the FDIC has found several reasonable solutions to deal with this problem.

Like depository insurance for banks, I think some reasonable pre-failure assessment could be made on these large financial firms. Remember, these firms would need to provide failure plans already. Those plans could be used to provide an estimate of the cost of resolution. The assessment fees could be based on that.

I also like pre-funding because it serves as a mild deterrent for firms becoming systemically risky. Remember, if a firm doesn't pose systemic risk, then it wouldn't need to pay into the fund. For those who must ante up, the less systemic risk a firm poses, the less that assessment would be.

And if the fund doesn't exist beforehand, where does the money come from to pay for resolution? Taxpayers will be responsible for providing the regulator a loan. Then, if the firm's assets don't cover the costs of wind-down, other firms must foot the bill to pay back taxpayers.

So, post-funding is an awful idea because healthy firms who played by the rules would ultimately pay for others' failure brought on by taking too much risk. That's neither fair nor sensible. Remember, this resolution authority wouldn't be in place to bail out firms -- it would exist to cover the costs associated with winding down large firms precisely so bailouts could be prevented. The after-the-fact assessments would end up hurting the good guys, not punishing the bad ones.

Here's that entire clip if you were interested in watching: