Reregulating finance: In praise of Doddery
At last a decent effort to tackle the problem of “too big to fail”
Mar 18th 2010 | From The Economist print edition
[Greg Ip] IN LATE 2008 the American government threw its weight behind its biggest financial institutions to avert a systemic meltdown. It worked. The banking crisis has largely passed, but the guarantees (many of them implicit ones) remain—and therein may lie the seeds of another crisis. America’s financial system is now dominated by a few dozen firms that are assumed to be too big to fail. The danger is that they will in the coming years exploit that assumption to add leverage, girth and risk, leading to another collapse and more bail-outs.
As regulators around the world try to work out how to bombproof the financial system, dealing with the problem of “too big to fail” is the most vexing issue. The initial response has been to prescribe thicker buffers of capital and liquidity in the hope that this will insulate banks from future crises. But this is a partial solution. Even the bigger buffers could not have prevented the worst blow-ups of the past two years. Regulators therefore need a way to unwind firms when they teeter on the brink of failure—a “resolution” regime, as it is known.
Such a system already exists for American banks that are regulated by the Federal Deposit Insurance Corporation (FDIC). For other financial firms and for bank-holding companies, regulators had two equally unappetising choices during the crisis. They could let a troubled firm go bankrupt and unleash panic and investor flight (Lehman). Or they could bail it out, rewarding creditors and counterparties at the expense of taxpayers (AIG). A middle ground is needed: a mechanism by which regulators can inflict losses on financial firms’ shareholders and creditors without sparking a wider panic.
So give a welcome then to the bill that Chris Dodd, chairman of the Senate Banking Committee, unveiled this week (see article). This doorstep of a bill deals with pretty much every aspect of finance, not just resolution. Whether it passes may well depend on a (far less significant) consumer financial protection agency it seeks to create; it also packs in other ideas, such as the “Volcker rule” seeking to stop banks engaging in proprietary trading. But its resolution part deserves support.
Mr Dodd would set up a special council of regulatory chiefs, with the power to insist that any financial company that is systemically important must be regulated by the Federal Reserve, whether or not it is a bank. If a firm got into trouble, the Fed, FDIC and Treasury, with the approval of three bankruptcy judges, could then impose an “orderly liquidation” upon it, paying off immediate dues and forcing shareholders and unsecured creditors to take losses.
To counteract the risk that these new measures are seen to increase the odds that big firms will be bailed out by the government, Mr Dodd would permit regulators to break up companies deemed to be at risk of failure and would compel big firms to put money into a resolution fund. The bill would further reduce the risk of contagion by moving derivatives trading onto clearing-houses, which would make it easier to determine firms’ exposure to counterparties and would guarantee payment in the event of a default. Making banks carry debt that automatically suffers a loss in the event of a crisis could help, too.
Something for nothing
The bill has its flaws: the process of invoking the resolution regime is cumbersome and the penalties for size are clumsily designed. Those should be improved. But many critics seem motivated by politics. On the left, some want banks cut down to size. That is unrealistic: reducing America’s biggest banks to truly innocuous dimensions would mean breaking them into 12 times as many constituent pieces. On the right, critics will argue that the resolution regime and broadened Fed oversight amount to an extension of state support to large financial firms. Yet today the likes of Citigroup and JPMorgan Chase enjoy that implicit backing—and give nothing in return. Above all, Mr Dodd’s approach is better than the status quo. If only more financial regulatory measures passed that test.
The original article is linked here.