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Too-Big-To-Fail Resolution: Why One Size Can't Fit All

posted by Adam Levitin

The debate over what to do about too-big-to-fail is heating up (see here (FRB) and here (BoE) and here (Simon Johnson for a summation and commentary).  A lot of the moves in the debate are well-rehearsed:  the moral hazard issues involved with too-big-to-fail have been amply noted elsewhere, and the problems with having firms create “living wills” that specify wind-down procedures is fairly self-evident—it is simply too hard for firms to predict the state of the world at the time a wind-down would be necessary, so firms might be committing themselves to suboptimal action.

I think it is important, however, to draw attention to a serious defect in proposals for a special resolution system for large systemically important firms.  There is simply no way to regularize a resolution system for too-big-to-fail institutions because they cannot be resolved without the commitment of government funds, and provision of government funds is a political decision that cannot be decided ex ante.  The nature of too-big-to-fail resolution is inherently political and locked into a preexisting system. 

Resolution of financially distressed firms is at core a distributive exercise.  There isn’t enough money to pay everyone on time.  Therefore, some creditors won’t get paid according to the original terms of their obligations.  Some won’t get paid in full and some won’t get paid on time and some won’t get either.  Deciding who has to take their lumps is a distributive decision, and that sort of decision is inherently political. 

For regular firms or non-systemically important financial institutions, we avoid having to deal with the politics of distribution on a case-by-case basis through a statutory system that allocates risk in advance.  Parties largely know where they will stand in the event of bankruptcy or bank insolvency and can deal accordingly ex ante.  This is one of the great strengths of regular insolvency systems. 

It cannot work, however, for too-big-to-fail institutions because resolution of a too-big-to-fail institution requires government funds, and provision of government funds is a political decision that cannot be decided ex ante both because of the way appropriations work and because the distributional questions are likely to be particularly sharp and nasty with systemically important institutions. 

The problem with too-big-to-fail institutions is not the institution itself—no one really cares about the distressed firm qua firm.  Instead, the concern is about the distressed firms’ counterparties and the impact its failure will have on them.  Sometimes the problem is from the ubiquity of counterparties and sometimes it is from the particular identity of counterparties.  In either case, the goal in resolving a systemically important institution is to protect a particular set of counterparties.  Who those counterparties will be, however, will vary by systemically important institution.  In one case it might be payment system creditors, in another it might be brokerage creditors, in another it might be bondholders, in another it might be secured lenders, and in another it might be unionized employees or retirees.  The unpredictable nature of the counterparties we want to protect means that distributional questions cannot be pre-set, and that makes them political issues, especially when the government has to provide active funding for the resolution.

Resolving a financially distressed firm of any sort requires funding, whether a bridge loan to a sale or liquidation or financing for a reorganization.  There are many financially distressed firms that are able to get private bridge loans until they can sell themselves or otherwise work out their problems.  To the extent that a financial firm, however large, can obtain such private funding, there is no need for a special legal resolution procedure.   A special resolution procedure might provide buyers of the firms’ assets with special protections, like a 363(f) sale in bankruptcy, but if I had to guess, lack of a free and clear sale order from a court or agency probably wouldn’t be the dealbreaker. 

Thus, a special resolution procedure is only really needed when a private resolution is not possible either because of (1) the lack of assets available as collateral for new loans, (2) the scale of the failed enterprise, or (3) the speed of the enterprise’s collapse, which makes due diligence for lending impossible.  A formal resolution procedure alone can only help with situation (1).  It is of no help in situations (2) or (3).

In situation (1) a priming lien procedure, such as in 364(d)(2) of the Bankruptcy Code, would allow for new money to be injected even if all assets were already committed as collateral.  To be sure, there very few contested priming liens granted in bankruptcy, and in bankruptcy, at least, existing secured creditors still have to get adequate protection, which might not be possible in all cases.  Moreover, a priming lien is only possible when there is collateral value left.  If the firm’s assets are worthless, they will not support a secured loan. 

A formal resolution procedure is of no help in situation (2) because the sheer size of the failed firm is so large that sufficient private funding is not available.  Is there enough private capital that could be readily assembled to provide a bridge loan to JPMorgan Chase, for example?  If not, then there is only one choice—the lender of last resort—the government.  Likewise, in situation (3), private capital might be available, but not on such short notice.  There are too many questions about the failed firm’s finances for lenders to commit.  The solution to this is to provide some sort of a third-party guaranty for the new financing, but where would this come from except the government. 

Thus in most failures of too-big-to-fail institutions, the government will have to provide funding for the resolution, and this makes the resolution a political issue.  For this reason alone, I think we are kidding ourselves if we believe that we can regularize the resolution of systemically important institutions.  It would be great if we could regularize too-big-to-fail resolution, but I don’t think it is possible to come up with any set of rules that we won’t break at the first sign of them creating distributional results that we do not like. 

So where does this leave us?  We could avoid the too-big-to-fail problem to some degree by splitting off riskier business lines (investment banking) from the systemically important ones (commercial banking--payments and deposits).  There isn't a lot of political appetite for this fight, however; the administration has made clear it isn't going to get into this mother-of-all-banking-regulation-battles.  So that means we're are going to have to learn to live with too-big-to-fail.  The administration believes it can regulate its way to safety.  I hope so, but worry that the nature of regulation in most cases is to play catch-up and it is often politically influenced.  Moreover, I'm not sure that all of the implications of too-big-to-fail have been thought through.  Allowing too-big-to-fail institutions has profound consequences on housing finance for example (good-bye GSE funding advantage...).  And having too-big-to-fail institutions means, at core, that the credit of these institutions is the credit of the national government.  Thus BoA, Chase, Citi, and Wells will be extensions of the US government.  UBS will be an extension of the Swiss government, Deutsche Bank of the German government, etc.  I wonder if this points toward some sort of neo-mercantilism....  

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Comments

"And having too-big-to-fail institutions means, at core, that the credit of these institutions is the credit of the national government."
1) I don't think that's true of the proposal - the essence of the proposal seems to be the opposite, that the government won't fully back all the debts of a too big to fail entity but will instead control the winddown more comprehensively. Also note this has been true in part since deposit insurance was introduced. Although there are other lenders to such companies.

2) In response to most of your post, I think the part of the proposal that would give the government the power to postpone debt service addresses much of it - they can postpone the need to fund for some time until Congress decides how much to fund.

I am not saying it is a good proposal because I haven't thought about all the unintended consequences. Personally I prefer the idea of having a strong equity layer, plus a sizable layer of debt that can be converted to equity by the company or regulators on short notice. But I think you have understated the proposals' attributes.

"I think we are kidding ourselves if we believe that we can regularize the resolution of systemically important institutions"

But why do you think that the goal of the "special resolution system" is to "regularize" resolution? My understanding is that it is designed to give the government the right under the law to both support a too big to fail firm and abrogate contracts in the way that would be possible in bankruptcy court -- with a lot more discretion than the typical bankruptcy judge enjoys.

I agree that every resolution will be political and also think that there are dangers to granting the authority to abrogate contracts. However, if the alternatives are to put the next AIG through bankruptcy or engage in another AIG-type bailout, then resolution authority starts to look like the least bad alternative. In a world with "too big to fail" institutions I just don't see how it's possible not to have a resolution authority -- even though every resolution will be different.

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