Non-Bank Resolution Process: House v. Dodd

The next stop as I continue to go through Senate Banking Committee Chairman Christopher Dodd's (D-CT) new financial reform proposal (.pdf) is how he intends to resolve too big to fail firms. As with most other sub-proposals I've discussed thus far, this one largely resembles what's found in the House bill. The big differences have to do with the creation of a "Orderly Liquidation Authority Panel" of bankruptcy judges to bless the resolution and the size of the fund to pay for it.

Both proposals call for firms to create resolution plans. In each proposal, the Treasury Secretary, Federal Reserve Chairman, relevant regulator or the firm itself requests resolution. The firm's failure must pose a systemic risk to the U.S. economy in order to utilize this process instead of the bankruptcy code. The Federal Reserve Board and the relevant regulator's board or commission vote on whether or not to proceed. A two-thirds vote is required. All of this is essentially identical for both Dodd's and the House's versions.

Orderly Liquidation Authority Panel

Next, the House version turns the process over to the FDIC, who completes the resolution process. Dodd's proposal, however, takes a quick detour. He wishes to establish a panel of three bankruptcy judges who must first approve. If they agree that the firm in question is, indeed, in default or in danger of default, then the FDIC takes over.

This is an interesting deviation, and I suspect that Senate Republicans may have had a hand in this provision, based on reports during the compromise process. I'm a little mixed on whether it's a good idea or not. I don't know that it would hurt much -- the judges must decide within 24-hours, so it would still be pretty quick. But then, a lot can happen in the world of finance in a day's time.

So the question, I think, is whether the value of these bankruptcy judges' opinion is worth the risk of what can happen in a day. If you're worried that the government officials working for the Fed and other regulators could needlessly order firms to wind down, then you might think so. If you are less cynical, then you might think it's a needless step. Frankly, I think if two-thirds of the Fed Board and firm's regulator's board/commission agree, then that's a high enough standard to order resolution.

How Much Will Resolution Cost

Each proposal would create a resolution fund, maintained by the FDIC, to pay for the dirty work of resolution. Both versions of legislation call for this to be created from assessments on large firms. The sizes of those assessments would be based on risk-ratings. In other words, if a firm poses more systemic risk, then it has to pay more into the fund. So far so good.

The difference is in size. The House bill calls for a fund of $150 billion. Dodd calls for just $50 billion.

Which size is better? Who knows? Past precedent would tell us that the Dodd's might come up short, but again, it's hard to tell. Excluding government-sponsored entities Fannie and Freddie, the biggest bailout was AIG at about $180 billion. But that probably wouldn't be the cost of its resolution. There's already evidence that the cost of the bailout will be significantly less, as AIG has begun selling its profitable divisions to pay back the government. It's likely that the cost will be below the $150 billion threshold. It's less likely, however, that it will be below the $50 billion threshold. Add in a few other big resolutions, like those of GM, Chrysler, GMAC, etc. and that $50 billion is looking even less adequate.

So why is Dodd's fund so small? I'm not sure. But I'd wager that the banking lobby would want as small an amount as possible -- remember it's mostly big banks who will end up paying for that fund. And banks would probably be a lot happier only having to pay $50 billion instead of $150 billion. Not that the banking lobby necessarily swayed Dodd, I'm just saying...

Both resolution authorities are a good start. I'd give a slight edge to the House plan, however, because I think its resolution fund is more sufficient. I also don't really see the point of the bankruptcy judge panel.