Yesterday, when former Fed Chair Alan Greenspan testified (.pdf) before the Financial Crisis Inquiry Commission, much of the hearing was focused on accusation and causation, with far less emphasis on solutions. Earlier today, Atlantic Correspondent Ben Heineman Jr. pointed this out, and highlighted the former central banker's call for regulatory reform. In doing so, he mentioned some of Greenspan's ideas. One, in particular, could mark a promising step towards solving the too big to fail problem.
The idea of a resolution authority sounds great in theory. A regulator that can neatly and quickly wind down a large financial institution would definitely have helped a few years ago. But on a practical level there's some fear that if only select firms are subject to the resolution authority, it could provide a competitive advantage. There's also some question of what liquidation costs would be covered through a resolution fund, as creditors would lend more cheaply to a firm if they know some of their investment is guaranteed even if an institution fails.
And that's where Greenspan's idea comes in. It roughly follows the bail-in theory described here, where large troubled institutions could convert debt to equity in order improve their capital levels, without needing to be wound down. The problem, of course, is that a resolution authority can't do this haphazardly, or the market would just have even more uncertainty. You can't leave such details up to the whims of regulators. Greenspan's solution: detail how this conversion would work. In his prepared testimony, he said:
The solution, in my judgment, that has at least a reasonable chance of reversing the extraordinarily large "moral hazard" that has arisen over the past year is to require banks and possibly all financial intermediaries to hold contingent capital bonds--that is, debt which is automatically converted to equity when equity capital falls below a certain threshold. Such debt will, of course, be more costly on issuance than simple debentures, but its existence could materially reduce moral hazard.
However, should contingent capital bonds prove insufficient, we should allow large institutions to fail, and if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility. That would grant the regulator access to taxpayer funds for "debtor-in-possession financing." A new statute would create a panel of judges who specialize in finance. The statute would require creditors (when equity is wholly wiped out) to be subject to statutorily defined principles of discounts from par ("haircuts") before the financial intermediary was restructured. The firm would then be required to split up into separate units, none of which should be of a size that is too big to fail.
Greenspan's point about moral hazard is very important. The big worry is that if large institutions will be rescued, then their creditors will provide them cheaper debt. But if investors' bonds will be converted to equity at some relatively unfavorable conversion rate, then suddenly creditors won't be as willing to provide big firms a significant funding advantage. Indeed, the idea of paying more for debt might even discourage firms from growing so large in the first place. The key would be to force most or all debt of systemically relevant firms to be subject to equity conversion when some pre-determined capital inadequacy trigger has been hit.