06.28.10

Financial Reform Bill, Part 2

Posted in Financial Markets, Politics and Policy at 4:56 pm

In this post I’ll address Section 2, entitled, “Ends Too Big to Fail Bailouts”.

From the summary:

Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

It smacks of hubris to talk of “ending the possibility” of another crisis that will require government intervention to save the system. As Minsky taught us, financial systems are inherently unstable. We should instead aim to minimize the probability of another crisis, minimize the expected severity of one should it materialize, and ensure that regulators have the tools to promptly and effectively deal with it.

Here are the “specifics”:

ENDING TOO BIG TO FAIL BAILOUTS

Limiting Large, Complex Financial Companies and Preventing Future Bailouts

No Taxpayer Funded Bailouts: Clearly states taxpayers will not be on the hook to save a failing financial company or to cover the cost of its liquidation.

That last statement is literal nonsense. It is absurd to think that the government would actually stand by that position in the event a failing institution threatened to bring down the system, nor would any reasonable person expect it. It’s akin to telling a nuclear power plant – “we’re tired of your safety violations, if you have a meltdown that threatens to kill everyone in a 200 mile radius, don’t expect our help in containing it.”

Discourage Excessive Growth & Complexity: The Financial Stability Oversight Council will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.

As is typically the case, the devil is in the details. Unfortunately, it appears the legislation prefers to leave all of the details to the discretion of the regulatory agencies, to be determined at some unspecified future date, and subject to change at any time.

Volcker Rule: Requires regulators implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial institutions supervised by the Fed will also have restrictions on proprietary trading and hedge fund and private equity investments. The Council will study and make recommendations on implementation to aid regulators.

This is less detailed than what was provided to the media on Friday. No mention of the 3% limit on bank investments in hedge funds. No mention of how customer transactions will be distinguished from proprietary trades.

I’m also sensing a common thread with the last sentence – establish a committee to study an issue and make non-binding recommendations to a regulator who has the discretion to do what they want (or not do anything) regardless.

Extends Regulation: The Council will have the ability to require nonbank financial companies that pose a risk to the financial stability of the United States to submit to supervision by the Federal Reserve.

Covered in the previous post.

Payment, clearing, and settlement regulation. Provides a specific framework for promoting uniform risk-management standards for systemically important financial market utilities and systemically important payment, clearing, and settlement activities conducted by financial institutions.

Gibberrish. If you want to view banks as utilities and isolate and protect the payments system, then re-instate an updated version of Glass-Steagall (I fully support this idea). Don’t pretend you’re accomplishing the same thing without actually doing anything.

Funeral Plans: Requires large, complex financial companies to periodically submit plans for their rapid and orderly shutdown should the company go under. Companies will be hit with higher capital requirements and restrictions on growth and activity, as well as divestment, if they fail to submit acceptable plans. Plans will help regulators understand the structure of the companies they oversee and serve as a roadmap for shutting them down if the company fails. Significant costs for failing to produce a credible plan create incentives for firms to rationalize structures or operations that cannot be unwound easily.

This is the “living wills” provision. These plans are likely to be as effective as BP’s spill disaster plans were, in the actual event they’re needed.

Liquidation: Creates an orderly liquidation mechanism for FDIC to unwind failing systemically significant financial companies. Shareholders and unsecured creditors bear losses and management and culpable directors will be removed.

I addressed this in my Preview post. There are significant questions that need to be answered here. For example, how can the FDIC deal with an institution that depends on short term repo financing to fund its assets without creating chaos in the repo market? Repos are not like insured bank deposits, which the FDIC can exercise control over because they guarantee them. Additionally, how will the FDIC resolve a multinational conglomerate with operations in numerous countries, all with unique bankruptcy laws?

Liquidation Procedure: Requires that Treasury, FDIC and the Federal Reserve all agree to put a company into the orderly liquidation process because its failure or resolution in bankruptcy would have adverse effects on financial stability, with an up front judicial review.

So the FDIC doesn’t even have full authority even within the US. The unanimous judgement of the FDIC, the Treasury, and the Fed is required to even start the process.

Costs to Financial Firms, Not Taxpayers: Taxpayers will bear no cost for liquidating large, interconnected financial companies. FDIC can borrow only the amount of funds to liquidate a company that it expects to be repaid from the assets of the company being liquidated. The government will be first in line for repayment. Funds not repaid from the sale of the company’s assets will be repaid first through the claw back of any payments to creditors that exceeded liquidation value and then assessments on large financial companies, with the riskiest paying more based on considerations included in a risk matrix

Putting the government ahead of all other creditors in the event a rescue is needed is a good idea. However, it appears this provision prevents a rescue from even being initiated if the FDIC does not believe it will not be repaid in full. This could serve as a straightjacket in the event of an actual crisis where time is of the essence.

Federal Reserve Emergency Lending: Significantly alters the Federal Reserve’s 13(3) emergency lending authority to prohibit bailing out an individual company. Secretary of the Treasury must approve any lending program, and such programs must be broad based and not aid a failing financial company. Collateral must be sufficient to protect taxpayers from losses.

Wait, what? Does this apply only to non-bank financials or to banks as well? Hopefully the latter (as would be indicated by the 13-3 reference). If the former, it would essential mean requiring Treasury consent for each and every Discount Window borrowing. More broadly, however, the reality is that in any financial crisis, the weakest firms will go first, and then contagion will spread to other firms. It won’t all happen simultaneously. Preventing rescues of individual firms effectively prevents rescues of the system itself.

Bankruptcy: Most large financial companies are expected to be resolved through the bankruptcy process.

Absurd, both in theory and in practice. Standard bankrupcty doesn’t work for large financial firms, which is the entire point of this legislation.

Limits on Debt Guarantees: To prevent bank runs, the FDIC can guarantee debt of solvent insured banks, but only after meeting serious requirements: 2/3 majority of the Board and the FDIC board determine there is a threat to financial stability; the Treasury Secretary approves terms and conditions and sets a cap on overall guarantee amounts; the President activates an expedited process for Congressional approval.

I like this provision. When the FDIC went and guaranteed the bonds of the big banks, it was clearly overstepping. The FDIC is supposed to provide DEPOSIT insurance, not become a monoline and insure bonds. While those steps may have been necessary, if the government is going to guarantee ALL bank liabilities, then we need to rethink banking on a fundamental level, which we’re clearly not prepared to do, given the limited scope of this legislation. At least this provision establishes some controls around the matter.

Overall, a very weak section. Some tentative steps are taken in the right direction, but much is left to the discretion of the regulatory agencies again. Additionally, claiming to end the posiibility of taxpayer-funded bailouts and declaring that systemic measures are not to be used to save individual firms, while not doing enough to actually minimize the likelihood and severity of future crises may have the perverse effect of constraining government action when it is most needed and make a future crisis worse than it otherwise would have been.

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