Viewpoint: Treasury Resolution Plan Solves Nothing

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After financial institutions lost almost $900 billion in the credit crisis, Congress and the Obama administration have proposed regulatory reform. Sensible proposals would begin with studies identifying the causes of the crisis.

The causes almost certainly include failures both within and between regulatory agencies. Rather than waiting for the report of the recently empaneled Financial Crisis Inquiry Commission, the Treasury Department has proposed an overhaul of U.S. financial regulation that would give key regulators additional powers. Included is a resolution procedure outside the Bankruptcy Code for bank holding companies and their nonbank subsidiaries, contained in the Resolution Authority for Large, Interconnected Financial Companies Act of 2009.

House Bill 3310 is the House Republicans' alternative proposal for the resolution of bank holding companies under the code. These competing proposals reflect different guesses about the role of financial regulation in the credit crisis and regulatory capacity to effectively resolve the financial distress of nonbank financial firms.

The Treasury's proposal would create a special resolution procedure for bank holding companies and certain of their nonbank subsidiaries whose activities present a risk of "serious financial effects" to the U.S. financial system. It would allow the FDIC to provide support to these companies, including making loans and purchasing their assets. Special rules for unsecured claims and standards for disposal of holding company assets also apply. The prospect of a special resolution procedure, with special rules and funding, gives bank holding companies an incentive to lever up risk to gain access to it.

This gaming of resolution procedure increases systemic risk (if any) and other "serious financial effects." The proposal thereby invites the problem it purports to control. No doubt its advocates will argue that the appropriate regulator can be counted on to prevent strategic gaming of resolution rules. This requires the regulator to identify when a bank holding company's activities risk "serious financial effects" on the financial system. It also requires effective supervision to prevent them from doing so. On both counts recent and earlier experience with regulatory forbearance makes the argument doubtful.

Support supplied by the FDIC is to come from appropriations funded by periodic assessments on bank holding companies. The subsidy will encourage bank holding companies to incur the risk. The plan thereby distorts the structure of bank holding companies, biasing it toward the effects the proposal seeks to avoid. To believe that regulatory supervision can control an industry encouraged to produce serious financial risk today seems too optimistic.

House Bill 3310 relies much less on regulators in the resolution process and much more on private initiative. It creates a new bankruptcy chapter (Chapter 14) for nonbank financial companies seeking to reorganize, to which almost all of Chapter 11's provisions apply. To gain access to Chapter 14, the institution generally must consult with a specified set of regulators. Their role is merely to facilitate a voluntary restructuring of the institution's debt. The institution or its creditors, not financial regulators, initiates a Chapter 14 case. By contrast, the Treasury's resolution procedure is initiated exclusively by regulators. House Bill 3310 plausibly assumes that stakeholders, whose dollars are at risk, can better decide whether and when to trigger the resolution of a nonbank financial firm's financial distress in bankruptcy. Unlike with the Treasury's proposal, stakeholders' incentives to do so are not distorted by the prospect of special rules that apply once a bankruptcy case is initiated.

Most significantly, House Bill 3310 prohibits the direct or indirect use of credit supplied by the U.S. government in bankruptcies. Debtors in bankruptcy therefore must fund themselves, if at all, through debtor-in-possession financing supplied by private lenders. The bill does not (and cannot) prevent tax dollars going to financial or nonfinancial companies outside a bankruptcy case. However, the proposed ban would effectively force Congress and regulators to bail out firms in a more visible fashion, with more political accountability all around. The Treasury's proposed resolution procedure would institutionalize a nontransparent bailout process.

The difference between the proposed resolution procedures is not between more and less regulation. It is over the role of regulators in resolving a financial company's financial distress. The Treasury's proposal places significant demands on a resolution authority that has no financial stake in its outcome. It requires regulators to know when a bank holding company's activities risk serious financial effects on the U.S. financial system. It also allows them to fund the company when private lenders presumably have refused to supply DIP financing. By contrast, House Bill 3310's proposal lets private parties with investments at risk decide whether and when to put the firm into bankruptcy. Once a firm is in bankruptcy, the reorganization process is determined by bargaining among stakeholders.

Although the precise causes of the present financial crisis have not been identified yet, the performance of financial regulators makes them poor candidates to run a resolution process for bank holding companies. Stakeholders with money on the line are better candidates to do so effectively.

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