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Explaining FinReg: Resolution authority

citiatms.JPG

There are plenty of bad terms in the financial regulation debate. My friend Matt Yglesias says that "FinReg" is the worst of them. Not me. I like "FinReg"! But I hate "resolution authority," which manages to take an easy and important concept and tell you nothing about it. So for this -- the second in the "Explaining FinReg" series -- we'll be talking about resolution authority.

A more descriptive -- if not lyrical -- term would be "execution capacity." We'll get to why in a minute. Before we do, we need to deal with the question of why we even need a special process for killing off a failing bank. Businesses fail all the time. Why should banks be any different?

The underlying issue here is, as per usual, the too-big-to-fail problem. "When big financial institutions fail," says Raj Date, a former managing director at Deutsche Bank Securities and the founder of the Cambridge Winter Project, "they have an immediate, catastrophic impact on the financial system. They live on borrowed money, and as they approach failure, their creditors try to get all their money back at once. So the firm begins selling all its assets into the marketplace very quickly. But when you're large, there's no way to move that volume of assets without cratering their prices. So now the types of assets the firm is selling drop in value. That means that everyone else's balance sheet is worth less, at least if they have these assets, too."

Here's the problem: Banks don't fail. They explode. They take other banks down with them. The easiest analogy is to a bomb. What happened with Lehman Brothers is that the bomb went off, and it took the financial sector with it, at least temporarily. That's, well, one way of handling a bomb. But it's not the preferred way. The preferred way is to defuse it. That's what resolution authority does, at least in theory.

What's important to understand about resolution authority is that you're not trying to save the firm. Quite the opposite, in fact. You're killing the firm. Any firm that goes into resolution -- or that taps into the liquidation fund -- is destroyed. Its management is fired. Its shareholders are wiped out. Its creditors lose money. It's broken into pieces and sold. That's why it's closer to execution than resolution, and why it's so deeply misleading to call this a bailout. No company wants to go through resolution. In fact, once a company goes through resolution, there's no more company. That's rather contrary to the spirit of a bailout.

Instead of savings the firm, resolution is trying to save the surrounding system. Let's say you're Mitch Bank, and after years of misrepresenting your assets, you're failing. You've been telling everyone you're worth 60. In reality, you're worth 50. But if you cause a panic and your creditors are demanding their money back and you're making your assets worthless by trying to sell them so quickly, you'll only be able to raise 30. The value of your firm is artificially depressed, and you're going to depress the value of all the other firms, too. Put simply, your failure will cause a bank run.

Enter resolution. Rather than letting the bank run happen, the FDIC steps in and takes over your firm. At that moment, your company is dead, but it's not gone. The FDIC keeps it running for awhile. It sells off your assets slowly so they don't become worthless. It forces your creditors to wait in line rather than letting them demand everything back the next morning. It slows everything down. Rather than a bank run, you now have a bank walk. It's not painless, but neither is it chaos.

That's how it goes in theory, at least. In reality, there are at least a couple of problems. The first is that resolution works better if you do it fairly early in the process. If you give the firm time to fail, and then give it time to try and save itself by making riskier and riskier bets (this happened with Washington Mutual), the end result is worse: The financial hole is deeper, and the market is nearer to crisis. But it's the rare group of regulators who will confidently declare a firm failed before the firm and the market agree that it's already gone. But if you wait until everyone agrees the firm is dead, you're already in a bank run.

The second problem is complexity. It's difficult to take apart an intricate, multinational megabank. Defusing a bomb is hard. Defusing a nuclear warhead in mid-flight is a lot harder. One of the ideas to counter this is to force big firms to create "funeral plans," which will literally be plans that show how to take them apart if the firm fails. This is a smart idea, and since regulators will have to approve the plan, the firms can't totally blow it off. But it's hard to believe that they'll produce anything that could operate as more than a rough guide in the event of a failure. It'll be like Ikea instructions: Useful if you already know what you're doing, but you wouldn't want to build a house based on them.

That's the nature of the enterprise, though. Even with resolution authority in place, the failure of a major bank is going to be a major problem. "You can't idiot-proof this," says Date. "If you want to idiot-proof it, you shouldn't have trillion-dollar banks operating in 35 different countries."

Photo credit: Chris Hondros/Getty.

By Ezra Klein  |  April 20, 2010; 5:34 PM ET
Categories:  Explaining financial regulation , Financial Regulation  
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Comments

According to the FDIC.gov website, there have been 50 bank "explosions" thus far this year after 140 "explosions" in 2009 and 25 in 2008.

Funny, there were no bank failures in '05 and '06 and only three in '07.

Are you sure you want to claim that these "explosions" happen all the time and that there are calamitous consequences to each "explosion?"

Posted by: onehanded | April 20, 2010 6:15 PM | Report abuse

Ezra,
Thanks for the explanation(s). Very helpful. Now pick up your trusty megaphone, step up on the soapbox, and yell it out on every corner of America. Or, do the 21st century equivalent of that.

As always, it's about message ... 'splaining it in such a way that average, everyday, hurried and harried citizens can understand it well enough to take appropriate action.

Go forth and inform the masses.

Posted by: onewing1 | April 20, 2010 6:31 PM | Report abuse

Not to get too picky, but this may actually improve your analogy. The preferred method to handle bombs or, in the miltary jargon, unexploded ordnance (UXO), is not to defuse it, but to blow it up in a controlled and safe manner. Defusing may happen if it can be done safely and is necessary to move the UXO, say to a bomb range. If it can't be moved, then the UXO team will add a small charge and pack the area with sand bags. All of this is, again, to prevent or minimize damage or injury.

Point being, this is exactly what the "resolution authority" or "execution capacity" will achieve. The bank/bomb is going to blow up either way. The question is whether you've got to fix a nasty pothole or rebuild the Murrah Federal Building. Defusing almost sounds more like the bailout scenario, where something is left behind that may be rehabilitated or used again, but in a "safer" fashion. That's not desirable with UXO or failed "TBTF" banks.

Posted by: kab7 | April 20, 2010 6:47 PM | Report abuse

I agree with you on the distastefulness of the term "resolution authority", but you want to call it "execution capacity" instead? Really? That's probably the only term I can think of which is more complex, less informative and more sinister at the same time. Picture the poor congressman at a town hall trying to explain what an execution capacity is. I'm not a big fan of FinReg either - the I is pronounced differently in 'fin' than in 'financial', which annoys me - but I can't think of anything better so I'll give you a pass on that one buddy.

Posted by: bigmandave | April 20, 2010 7:26 PM | Report abuse

The first is that resolution works better if you do it fairly early in the process. If you give the firm time to fail, and then give it time to try and save itself by making riskier and riskier bets (this happened with Washington Mutual), the end result is worse.
************

so the only real usefulness of this "resolution authority" will manifest itself as nameless, faceless unelected regulators exercising authority under regulations written into law by other nameless faceless unelected regulators (there might be a broad statutory framework, but the regulations promulgated pursuant to it will really give shape to resolution authority) to take over a large financial institution based on claims of prospective problems that the public will likely not understand let alone have the ability to evaluate the legitimacy of.

why dont we just stick to not creating junk assets by mandating junk loans enabled by OTHER government regulators like Fannie Mae?

if government doesnt create the problem, there will be one less for it to clean up.

Posted by: dummypants | April 20, 2010 7:40 PM | Report abuse

Ezra, your explanation is accurate as far as it goes, but we're dealing with the feds here, and olitics will be a part of every equation. The dems want their bail out fund not so they can shut down banks in a more orderly fashion, but so they can have more time to choose politically connected winners rather than the market doing the same thing without government interference. Have you forgotten Chrysler and GM? The government wiped out the retiree bondholders and "gave" ownership to the UAW, a gift I'm sure they are tickled pink to have. I can just see Geitner and friends selling off assets at pennies on the dollar to major democrat fundraisers, etc, at the expense of the bank shareholdres. Look what they did to the CEO of BoA. They forced BoA to complete a shaky transaction, and then went after the guy with every tool at their disposal to get back at him for telling the American public the truth about the actions. The new financial regs don't even touch the rating agencies, Freddie Mac and Fannie Mae, argueably the primary demons in the entire sub-prime mess. Go watch the hearings on YouTube. You'll see Barnie Frank, Chris Dodd and others literally attack the auditor honestly telling them that Freddie and Fannie were grossly overextended and unsound. Now Dem culpability has been completely swept under the rug. Rediculous.

Posted by: hdc77494 | April 20, 2010 11:57 PM | Report abuse

Then say ResAuth.

See how much better your feel when you don't have to use real words?

Posted by: pj_camp | April 21, 2010 8:59 AM | Report abuse

A few points you failed to make:

The $50B fund is not even close to being enough to unwind a failing Citibank - the shortage would have to be made up ultimately by taxpayers.

There are all kinds of poison pills banks could adopt to purposely make it difficult to close them or break them up. Of course, they would never do that though?

The FDIC has no experience taking over anything as large as Citibank and the regulators who will be implementing this will for the most part be the same ones as before.

Instead of adopting feel-good half measures, why not just take the too big to fail banks and break them up - now?

Posted by: invention13 | April 21, 2010 9:39 AM | Report abuse

I humbly suggest that Resolution Authority be called "The Green Mile". It works on at least two levels - a reference to the bank's impending demise, and "Green" as a reference to the cash which is required to keep the inmate - er, bank - alive until it can be killed.

Wordplay! Huzzah!

Posted by: BigTunaTim | April 21, 2010 11:56 AM | Report abuse

How about calling it "Updated FDIC Bankruptcy Rules"?

Posted by: tomveiltomveil | April 21, 2010 11:59 AM | Report abuse

Ezra. For a better analogy, let's call it "FUNERAL EXPENSES"

Posted by: CKH2 | April 21, 2010 3:15 PM | Report abuse

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