Fed's Lacker: Dodd Bill Won't Cure Too Big To Fail

One of the major sticking points in the Senate's financial reform bill involves the non-bank resolution authority. Its architect, Banking Committee Chairman Christopher Dodd (D-CT), wants to allow regulators sufficient authority to stabilize the financial market in times of turmoil. Republicans worry that this flexibility could result in more bailouts. Richmond Federal Reserve President Jeffrey Lacker articulated the latter view during an interview with CNBC's Steve Liesman that aired this morning. Lacker thinks Dodd's bill is too soft on forcing bankrupt firms to fail.

Here's a transcript of the relevant part of the discussion, though the whole video can be watched at the bottom of the post:

Lacker: The issue of our time has to do with the government safety net for financial firms. And it's grown tremendously, and containing that, establishing clear boundaries of that, is the number one priority. As I read the Dodd bill and the mechanism it sets up for the resolution authority, it doesn't strike me that it's likely to help us there. And in fact, it seems to me like a major danger is that there's going to be more instability in financial markets instead of less.

Liesman: The Dodd bill allows for a three-bankruptcy judge panel to declare insolvency. It allows losses to go to unsecured creditors; it allows management to be replaced and shareholders to be wiped out. How much clearer could the government be in this bill that there will be real losses to investors?

Lacker: It allows those things, but it does not require them. Moreover, it provides tremendous discretion for the Treasury and FDIC to use that fund to buy assets from the failed firm, to guarantee liabilities of the failed firm, to buy liabilities of the failed firm. They can support creditors in the failed firm. They have a tremendous amount of discretion. And if they have the discretion, they are likely to be forced to use it in a crisis.

Whether financial reform should be stricter on failing firms isn't a simple question. For example, imagine a firm that should fail in its current form, but through restructuring its debt and equity could survive. Should it just be wound down and obliterated, or should a regulator work to restructure the firm (assuming no loss to taxpayers)? The harder line would call for wind down, but Dodd's bill might allow for restructuring.

Even though this question is a hard one, financial reform shouldn't leave it unanswered. That's why Lacker is right to call for more specificity in the powers of the resolution authority. What "costs" will be covered by the resolution fund? Under what circumstances can a firm be restructured? These sorts of issues should be specifically defined.

For example, can the resolution authority perform a debt to equity conversation to enhance capital levels of a troubled firm to keep it afloat? If so, under what conditions? Those details should be explained so that creditors can understand how that might shake out. Will the resolution authority cover a part of a firm's derivatives exposure and pay out counterparties? If so, how many cents on the dollar can a counterparty expect?

Working out such details will serve to eliminate market uncertainty. It should also destroy the perception that systemically relevant firms would remain too big to fail. Instead, investors could just look at how the resolution process would work and figure out under what conditions a firm could survive a government resolution. (And survival shouldn't be easy.) Of course, determining such specifics ahead of time would make for more accurate risk-based assessments paid into the resolution fund by firms as well.

And although Lacker doesn't mention it, the resolution authority's rules should apply to all firms, not just large ones. That way, investors can evaluate all market participants on a level playing field. If only the big firms receive the potential advantages that a resolution authority provides -- even if explicit bailout isn't one of them -- then smaller firms will experience a competitive disadvantage when trying to acquire funding.