We seem to be going back to the world before the crisis in number of respects. The first is that the Financial Times is again running rings around the Wall Street Journal on markets and financial services industry coverage. The crisis forced the Journal to throw a lot of resources on those beats, with the result that it became pretty competitive.
The second is that the authorities seem to be engaged in a weird form of cognitive dissonance. They clearly can’t pretend the crisis didn’t occur; if nothing else, all the extra new studies and rulemaking imposed by Dodd Frank make that impossible. Yet in every manner imaginable, they behave as if no financial markets near death event took place.
The object lesson of the evening is a story in the Financial Times on a battle between the FDIC, which is responsible for resolution of systemically important firms under Dodd Frank versus the Fed and Treasury. The struggle is over how many non-banks are to put on the systemically important watchlist as required by Dodd Frank. No one wants to be on that roster; it leads to the potential to be subject to all sorts of proctological examinations.
The weird part here is that normally, in the wake of a disaster, anyone in an official role anywhere within hailing distance of the problem who nevertheless (career-wise) is alive to tell the tale normally goes into overdrive in fighting the battle they just lost (the security theater at airports in the wake of 9/11 is a classic manifestation). Nevertheless, correcting any past errors would seem to be a minimal response; being forward looking is even better.
But in the wake of the crisis, the most powerful US regulators, the Fed and the Treasury, have reliably been opting for less rather than more in terms of safety measures, despite the horrific past and ongoing costs of the meltdown. Not that this strange new attitude to disaster prevention isn’t becoming pervasive in the US. I was stunned to learn on a visit to New Orleans at the end of last year that after Katrina, the breaks in the levees were merely filled in, rather than being rebuilt to have their height increased as was clearly warranted.
Economics of Contempt earlier highlighted the relevant language:
Section 113(a)(2) requires the FSOC to consider 10 specific factors in determining whether a firm is systemically important:
(A) the extent of the leverage of the company;
(B) the extent and nature of the off-balance-sheet exposures of the company;
(C) the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H) the degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) the amount and nature of the financial assets of the company;
(J) the amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K) any other risk-related factors that the Council deems appropriate.
EoC (predictably) argued for what has turned out to be the Fed/Treasury position, which is that only a small number of non-banks be included (he volunteered AIG, GE Capital, and Prudential). The FDIC is thinking more along the lines of thirty to forty firms, with some big hedge funds among the targets.
I’m in the FDIC’s camp. Harvey Miller, the dean of the bankruptcy bar, stated before Lehman failed, meaning when financial firms were less concentrated than they are now, that the collapse of even a mid-sized broker dealer roiled markets. That alone suggests that any list of systemically important firms should be more rather than less inclusive.
Moreover, Dodd Frank is at best suited only to the resolution of a purely domestic player, and one lacking much in the way of over-the-counter markets exposures. As Josh Rosner recounted in recent Congressional testimony:
Instead of making surgical fixes to the Bankruptcy Code, Congress and regulators created the poorly designed OLA [Orderly Liquidation Authority]. At its heart it is a bailout regime. Shortly after the seizure of a large firm under Orderly Liquidation, the government may disparately treat similarly situated creditors of the financial institution that are deemed “systemically important”. The Fed may also deploy a broad-based lending program to facilitate the cash needs of other market players. (Supporters of Dodd-Frank like to say that it is not a “taxpayer bailout” because the government will recoup these initial bailout expenditures by taxing unrelated private financial institutions in the years following the bailout.) It is, nonetheless, a government-run giveaway where regulators, mostly unchecked by judicial review, get to decide who receives liquidity that would otherwise not be available.
Another fundamental flaw of OLA is that there are now two very different regimes under which a large financial firm can fail – the Bankruptcy process and the Dodd-Frank process. This is very unsettling to creditors and other stakeholders of the large firms because without adequate foresight of which resolution process the firm may enter, it is impossible for a creditor to adequately calculate one’s downside. (Even more troubling is the fact that stakeholders will have no idea which process will be employed until the firm is already seized by the regulators or has entered Chapter 11.) Regulators will argue that there is some level of certainty due to the fact that in either a chapter 11 or a Dodd-Frank Orderly Liquidation, a creditor must receive at least as much as the creditor would receive in a chapter 7 bankruptcy. However, this only demonstrates the regulators ignorance of how markets for distressed claims function, since there are multiple layers of analysis used by claims holders to determine the likely return on a claim not the “floor” return on a claim. In reality, Dodd-Frank and the Bankruptcy Code are two very different processes with very different outcomes for creditors. The value of a firm in its “going concern” state is dependent on the resolution process employed when it fails. All non-financial firms and most financial institutions use the Bankruptcy Code; commercial banks use the FDIA; broker-dealers use SIPA. There may be different systems for different types of firms, but there are not, and there should not be, multiple processes for the same firm.
Rosner does point out that designating a firm as systemically risky could lead to moral hazard (the managers presuming it was too big to fail). He is also concerned that regulators will not take the necessary steps to supervise systemically important firms aggressively enough, and in particular, are likely to fail to prod them to divest businesses or otherwise restructure operations if they submit resolution plans that are inadequate.
Nevertheless, the aggressive lobbying efforts that firms like Paulson & Company are making to try to have themselves excluded from the FSOC list suggests that if tagged, they would take efforts to reduce the riskiness of their operations so as to have the designation removed. That alone suggests that when in doubt, the authorities should put more rather than fewer players on the list.
