Death Panels for Wall Street?

March 18th, 2010 at 5:27 am | No Comments |

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Deep in the recesses of the financial regulatory reform bill likely to come before the Senate sometime soon, ed careful readers come across something called “resolution authority.” This new power — arguably the biggest expansion of federal authority in the proposal Sen. Chris Dodd (D-CT) has proffered — would give federal regulators power and resources to wind down troubled financial services giants in much the same way that courts oversee bankrupt companies in other sectors. The idea makes sense on the surface but its execution seems likely to cause at least as many problems as it will solve.  Quite simply, ed the power grab necessary to create “resolution authority” doesn’t make sense.

Some background on the nature of financial services regulation is necessary to explain why such sweeping “resolution authority” seems attractive to many policy makers.  In general, banks and insurers can’t file for bankruptcy and, when investment companies do, they are expected to return client assets in full. Instead, financial services firms that run into trouble collapse onto a variety of government-run or mandated entities which work to unwind operations and return something to consumers.  These entities have different jurisdictions. As a result, any diversified financial services company participates in the Federal Deposit Insurance Corporation (for bank deposits), the Securities Investor Protection Corporation (for investments) and more than fifty mostly-state level “guarantee funds” which back insurance products. This is why  the New York Fed and later, Treasury, felt the need to create a bespoke rescue process when mega-insurer AIG ran into trouble: its activities covered every existing guarantee agency and the state insurance guarantee funds likely to end up with a big part of the mess absent additional federal action had no ability to deal with it.

All this sounds like a good case for a “resolution authority” that would give federal regulators a permanent way of dealing with a collapse like AIG’s.

But there are at least three major problems with such an authority.  First, under Dodd’s proposal and the one that passed the House of Representatives last year, any entity with resolution authority would sit on top of the existing agencies so firms would still have to participate in all of the existing agencies and a new super-agency. This would further blur already hazy lines of authority, create conflicts between regulators, and encourage rule-breaking firms to play regulatory bodies against each other. Second, even if it does have taxing authority, an entity with resolution authority couldn’t collect the trillion (literally) or so dollars needed to pre-fund a future mega-bailout. Even if it could, keeping that much capital sitting in safe assets would likely do more economic harm than taking on new debts to fund a truly necessary bailout. Finally, the distinctions between the different guarantee authorities evolved for a reason. For example, while American governments have protected some bank deposits against loss since the early 19th century, nobody thinks that the government ought to provide an assurance of investment returns. But a single authority responsible for wind-downs of broadly diversified firms would face inevitable pressure to make all consumers whole regardless of the products they purchased.

Given all this, it’s tempting to argue that the government shouldn’t guarantee any financial services products at all.  Nice as this may sound to radical libertarians, however, it has no chance of moving forward since certain widely owned products like “savings accounts,” and “multi-peril homeowners’ insurance,” are, by definition, backed by government guarantees.  Consumers all over the country have a legitimate reliance interest in continued public guarantees and efforts to eliminate them could never gain serious political support anyway.

Therefore, it’s possible that the nation and its financial system would do best if Congress doesn’t bother with a “resolution authority” at all. While a real consensus exists on some regulatory reforms, far-reaching resolution authorities proposed to date would create more problems than they would solve. They simply aren’t good ideas.

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