Explaining FinReg: Resolution authority
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.
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