I have one nagging concern about both financial reform proposals out there that I haven't really addressed yet. Both bills seek to create a non-bank resolution authority. That sounds great. But in order to unwind a firm quickly and neatly, then you need to have some money to work with. Since it's pretty likely that the firms being unwound can't cover the entire cost involved -- they are, after all, bankrupt -- each proposal includes a resolution fund to help pay. I worry that access to this fund in the resolution process would still provide these firms a competitive advantage -- even though they could fail.
The question, I think, is precisely what this resolution fund will pay for. We can be pretty sure that it won't pay equity holders anything -- they'll be wiped out entirely. But with creditors, things get a little more complicated. Will they all be wiped out? If not, any who aren't essentially hold debt with a government guarantee. Even if the firm is wound down by the resolution authority, those debt holders can be sure they'll be made whole.
That would provide the firms who are subject to systemic risk authority a distinct advantage. It will provide them with cheaper borrowing costs. After all, if a creditor thinks that the debt of one firm will be paid for through the resolution fund if it fails, then she'll charge less for that debt than for debt from a firm that isn't subject to systemic risk regulation.
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.
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