And what about derivative counterparties? Think AIG on this one. When it was bailed out, lots of banks collected big checks on payouts they were owed by AIG from derivatives they held that AIG backed. Presumably a resolution authority would seek to pay out some portion -- if not all -- of derivative obligations. As I see it, that's kind of the point. Otherwise, you'd end up in a situation where a financial crisis could ensue once again. If counterparties don't know that they'll be made whole, their counterparties might get scared, liquidity freezes up, and we've got a big mess on our hands again.
The problem is that if you guarantee any aspect of a firm's exposure, then that provides it an advantage. Imagine if AIG's CDS was all paid back through resolution. Let's say the failure plan even required it be paid out at 80 cents on the dollar, rather than at par. If I'm buying CDS, then that's still a pretty good deal compared to a firm that isn't big enough to qualify for access to the government's resolution fund through failure. Big firms that do have access will certainly have a competitive advantage if any costs of resolution are covered.
And if no such costs are to be covered, then just what exactly is the purpose of the resolution fund -- and how would a new resolution authority provide any more market stability than if the firm just failed the good, old fashioned way? I have trouble wrapping my mind around how this resolution authority could exist without some advantage being attained by those firms under its umbrella.
This is a major concern, because it would create a world where the big firms continue to grow more rapidly than the small ones -- because they have a distinctive advantage. That's precisely what we don't want. One potential solution would be for all non-bank financial firms to have access to the resolution fund though failure, under the same set of rules. For example, Joe's CDS shop's clients would also get 80 cents on the dollar for the CDS he sold if it fails, just like AIG's customers. This would kind of be like how all banks have the same depository insurance benefit currently.
Otherwise, breaking up large firms would be the only possible solution left. But I think that's a pretty poor option in practice. I'm skeptical that regulators would even know how big is too big or how interconnected is too interconnected.
So for now, I still support the idea of a resolution authority, but I would like to hear more about how the playing field will be kept level. Someone needs to explain how a non-bank resolution authority can nicely wind-down only large firms without also giving those firms some competitive advantage over smaller ones. Otherwise, regulators must provide the same benefit to all firms. Current resolution authority proposals sound nice in theory; I just worry about their practical application.