At a weekly National Economists Club luncheon in June, guest speaker Robert Bliss had a sly, tongue-in-cheek confession about the economy. "It's really nice to have this crisis," said the Wake Forest economics professor, "because papers in the obscure journals are getting read by people."
He got some laughs from a Washington, D.C., audience that probably reads technical periodicals like the Journal of Financial Stability. But Bliss was right. This year, while the Obama administration was devising its plan for creating on a systemic risk regulator, the Congressional Research Service did some homework on the implications of interdependent risk by dusting off some academic papers published prior to the 2008 meltdown by Bliss and his research colleague, George G. Kaufman of Loyola University in Chicago. (Both are former senior Chicago Fed economists, as well).
Two papers in particular - a 2006 study on systemic derivatives risk and a 2005 report comparing bank insolvency procedures to the U.S. corporate bankruptcy code - served as primary sources for an April CRS report on the unique insolvency challenges facing a too-big-to-fail regulator over insured banks or non-bank financial giants. As the professors saw back then, there were regulatory gaps and potential market catastrophes that neither bankruptcy law nor insolvency procedures for chartered banks could stem without federal intervention. The prescient research and recent history spell out the dilemmas over fail-safe planning, which, in the professors' opinions, are not being fully addressed by Congress or the president.
"What the Treasury has proposed is nothing more than applying bank insolvency to firms that are systemically important," Bliss says. "The detail of how it works is exactly identical to what we've been doing with banks for 20 years."
What is needed is a crash-course on the mechanics of both the bankruptcy-led or receivership/conservatorship remedies. The first lesson, Bliss says, is to understand the unaligned, "markedly different" outcomes for each. "The claim of bank insolvency process is very quick and very efficient, whereas bankruptcy is neither efficient nor quick, but supposed to be fair," Bliss says.
Fair or not to bank creditors or uninsured depositors, the Federal Deposit Insurance Corp.'s legal priority (since 1993, under the "least-cost resolution" doctrine) is to protect insured depositors and the Deposit Insurance Fund. While the FDIC has done a good job of sustaining uninsured depositors and claimants in failures, Bliss said, extending that practice to multi-billion asset, multi-national firms could be at cross-purposes with both alacrity and cost.
Another problem is the systemic institutions' evolved dependence on short-term wholesale funding and derivatives. If a broker/dealer were subject to an FDIC-type takeover, funding would dry up and counterparties would pull contracts without explicit federal guarantees, Bliss said (so much for moral hazard). Any resolution process would likely need a complex apparatus, like a central registry, to continually track positions of contracts. Under receivership procedures today, fulfilling legacy contracts (any contracts) are at the FDIC's discretion. "They have one day to think about [a contract] - they can either close it out or pass it on," Kaufman says.
The derivatives problem with a systemically important institution is why bankruptcy wouldn't be the magic bullet, either. In the 2005 federal bankruptcy reform act, derivatives were exempted from bankruptcy court stays - under a widespread assumption it was critical to preserving systemic market soundness. With this exemption in place, bankruptcy procedures could do little to stem a run by derivatives counterparties looking for their money.
Bankruptcy law is also unequipped to address a common bank insolvency practice to aid creditors: the "off-set" of outstanding loans with uninsured deposits, in which a claimant can benefit from the net balance. Bankruptcy procedures could also, in some instances, destroy more asset value because of its lengthy, deliberative process, said Bliss.
But Bliss also said ensuring fairness with negotiation rights and being in a neutral venue - the FDIC's DIF fund responsibility make it a vested party in an insolvency - is worth considering, especially with the potential politicizing of a systemic regulator. When FDIC chairman Sheila Bair "was quoted as saying it's important to impose losses" on creditors, Bliss says, "that's kind of an adversarial mindset which worries me, as opposed to bankruptcy, where the goal is not to impose losses but to minimize losses...where everybody gets a fair shake."
As Congress continues debating who should regulate systemically important institutions, it'll have an advantage that Bliss and Kaufman didn't have for their research: real-world examples. Still, that doesn't make their decision any easier. Many of the actions taken by the Federal Reserve, the Treasury, and the FDIC - from bailing out AIG and seizing Fannie Mae and Freddie Mac to letting Lehman Brothers fail - have had unintended consequences, showcasing ways mainly how not to unwind these institutions. Kaufman says there is no right answer. "It's a question of what do you prefer?"