How Financial Reform Creates Too Big To Fail Firms

The prevailing debate between Republicans and Democrats on financial reform is whether the new bill institutionalizes the too big to fail problem. Democrats swear it doesn't, since the legislation also includes a new non-bank resolution authority which will make quite certain that all firms can, and will, fail if they run into trouble. Republicans haven't developed a very sensible criticism to this, but they could. While the resolution authority ensures that big firms fail, it would also almost certainly provide them some advantage.

The FDIC will take over big troubled financial firms. It will then do whatever it must to both stabilize the financial system and maximize the value of failed firms' assets, so to minimize the costs of the resolution process. In order to achieve financial stability, the FDIC will have to cover many of the big firm's obligations. After all, that's kind of the whole point. Consequently, these counterparties, customers, creditors, etc. will prefer to do business with companies that fall under the resolution authority's umbrella. That should provide these big regulated firms a competitive advantage over smaller ones.

Imagine two insurance companies -- one large one that falls under the resolution authority's reach and another smaller one that doesn't. Each offers a comparable product that pays out if some condition is met. Which one would you rather do business with? Easy: the one under the government's resolution authority. That way, if it fails, in order to stabilize the financial system, you'll be treated more favorably than you probably would in bankruptcy court if the smaller one fails.

Financial reform appears to try to deal with this problem. Let's turn to law firm Skadden's great summary (.pdf) of the new resolution authority for the detail. It explains that the FDIC will have to assess firms to claw back money that was paid beyond what should have been provided (presumably in a regular bankruptcy):

These assessments first must be made against any claimant that received additional payments from the FDIC pursuant to its authority to treat some creditors more favorably than others, as described above. Any assessment against a claimant must be in an amount equal to the difference between the aggregate value the claimant received from the FDIC on its claim under the Act, on the one hand, and the value the claimant was entitled to receive solely from proceeds of the liquidation of the covered financial company, on the other hand.

But that's not all:

If the funds recouped from claimants are insufficient to satisfy the obligations to the Secretary, then the FDIC may assess "eligible financial companies" and certain other financial companies.

In bankruptcy court, the judge can't turn to the financial industry to cover whatever additional capital the failed firm should have had to make good on its obligations. So even though the legislation appears to say that excess payments will be clawed back, it also implies that these payments could be more than they would have been through a regular bankruptcy, where the proceeds are limited to the failed firm's assets.

And, of course, it would sort of have to be the case that the FDIC gives claimants less of a haircut than a bankruptcy judge would have. That's sort of its purpose: it's trying to stabilize the financial system. If investors and banks have to worry about how much of proceeds awarded to a seemingly healthy firm through a resolution might be clawed back, then that would leave enormous uncertainty in the market and fail to calm an impending financial crisis. These other companies owed money by the wound down firms might be riskier than they appear if that capital is only temporary.

It's hard to see how the resolution authority can have it both ways. It can't only ultimately award a firm's counterparties, customers, and creditors what they would get in bankruptcy court and also ensure market stability. Consequently, it will almost certainly opt for the latter, which provides an advantage to any firms that would be resolved through this new regulatory authority. And that creates a breed of firm that will look more favorable to do business with than its smaller competitors.