Monday, November 23, 2009

The world according to Fed: resolving large financial institutions

In order to address the "too large to fail" issue the Fed has begun a campaign to promote their solution: some form of a resolution regime for systemically significant financial firms. The Fed's goal is to broaden their regulatory reach and to prevent the US Congress (filled with populist fervor) from trimming the Fed's power. What the Fed is proposing is actually a complex piece of legislation that will span beyond the banking industry. It has the potential to engulf large insurance firms, financial advisory and securities firms, and even asset management firms.

Dan Tarullo's speech (included below) provides a good outline of such legislation. Other Fed governors are starting to carry the same message as part of their campaign to vastly boost the Fed's powers. You can see it gently inserted on slide 26 in James Bullard's recent speech for example (see included). Here are the three pillars of this special resolution process:

1. When the Fed determines that a institution that is on their too large to fail list is about to fail (or take some other action that threatens the financial system), the central bank would invoke the "special regime" to take control of the institution. The Fed would then have a broad authority to dissolve or restructure this company, including liquidating assets and businesses, as well as the ability the ability to set up a temporary firm to purchase and "warehouse" certain assets. Note that this is similar to the authority the FDIC holds in dissolving banks they regulate.

2. The shareholders and some creditors of the failing firm would bear the losses associated with this process. It's not clear to what extent the creditors would be hurt by this, because The Fed would clearly have to step in and guarantee some of the liabilities of the organization (for example institutional bank deposits or repo financing). Otherwise such liquidation may be no different than what the courts would do in a bankruptcy scenario. The model may become similar to that used in restructuring the US auto firms - some form of direct negotiations with creditors. Depending on the level of Fed's independence, the process may even become politicized.

3. The Fed would set up an "insurance fund" similar to the FDIC's fund to be used in orderly liquidation operations. The "too big to fail" organizations (again not just banks) would be assessed ongoing fees to capitalize the fund. Over time the fund would be significant enough to support a failing institution through the restructuring/liquidation process.

Developing such legislation is a massive undertaking with numerous key unanswered questions such as which organizations would be deemed too big to fail, how will the creditors be dealt with, how would the regulation of these institutions be different, will this make the Fed too powerful, etc. The model of course is the FDIC's bank takeover process - but on steroids, as these institutions are infinitely more complex. Of course no matter what form this process takes, it does create a form of moral hazard by backstopping certain risks in the financial system.


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