Since that terrible week in September 2008 when Lehman Brothers failed, AIG was taken into conservatorship and Bank of America was "encouraged" to acquire Merrill Lynch, the concept of too big (to be allowed) to fail has been the central issue on the minds and in the rhetoric of regulators and politicians.
When an institution becomes insolvent, its financial commitments exceed the value of its assets, creating an economic injustice. At least some of the creditors will not receive the full value they were promised. A bankruptcy proceeding is a means of allocating the impact of this injustice across different classes of claimants. In most situations this is purely a matter to be thrashed out among the creditors. The problem is that, given current institutional arrangements, failure of the largest financial institutions could lead to a slew of additional failures, driving the economy into a severe recession (as happened in 2008) or even a second Great Depression. Faced with such a prospect, a publicly funded rescue, distasteful as it is, will often be deemed preferable for society as a whole to suffering the consequences of a failure. Our institutional arrangements must be revised to prevent the need for this kind of devil's choice.
The problem is that liquidation in a traditional bankruptcy is an agonizingly protracted legal process. Today, however, supervisors may have at most two or three days to engineer a resolution, force a traditional bankruptcy or initiate a government-assisted bailout. Effective resolution of a major financial institution requires legal authority for supervisors to maintain operations while establishing a binding allocation of the shortfall in the value of the assets relative to creditors' claims. But accomplishing this in a matter of weeks or a few months requires more than just the legal authority to do so.
If "too big to fail" is ever to become a thing of the past, supervisors must have access to the type of detailed information that allows an effective resolution plan to be developed in advance of a crisis.
The Office of Financial Research proposed in the Dodd bill is designed to equip regulators with the information they need to execute an effective resolution of even the largest financial institutions. It is vital that the office have the authority to require reporting based on the nature of an activity. Some institutions are seeking exemption from the requirements based on their legal form. This is an open invitation to widespread avoidance of reporting that would leave society exposed to the risk of bailing out "too big to fail" institutions. Maintaining the level of reporting detail and the scope of required application in the final conference bill is essential if Congress is serious about addressing the "too big to fail" problem.
