Bailing out of bailouts

Sunday, April 25, 2010

NO ISSUE LOOMS larger in the Senate debate on financial regulation than "too big to fail." As long as a few giant financial institutions dominate the system, they will enjoy artificial competitive advantages based on the market's perception that the U.S. government would never let them go under. This enables them to accumulate excessive risks, ultimately at the taxpayer's expense. What's the best solution to this intractable problem?

Basically, there are three possible approaches.

The first would be a firm and simple no-bailout policy. Any distressed financial firm, regardless of its size, would be allowed to enter bankruptcy, where its creditors would have to take their chances with a federal judge. The market signals sent by such a policy couldn't be clearer; creditors would have a strong incentive to police their counterparties' finances, and no taxpayer dollars would be involved. There are just two problems. "No bailouts" is a bluff that markets have successfully called too often in the past. And bankruptcy works poorly in a broad crisis, where the costs to society of a panic-inducing collapse can exceed those of even a pretty expensive, but swift, bailout.

The second approach is embodied in a proposal by Sens. Sherrod Brown (D-Ohio) and Ted Kaufman (D-Del.), which starts from the logical premise that "too big to fail is too big to exist." They suggest limiting banks to no more than 10 percent of all deposits -- roughly what Bank of America has today -- and to non-deposit liabilities of no more than 2 percent of gross domestic product. This, too, is more attractive in principle than in practice. The systemic risk posed by a large financial institution varies according to not only its size but its degree of leverage and interconnectedness with other market players. Thus, even if Bank of America were a quarter of its present size, government might be tempted to rescue it in a crisis. Subjecting huge banks to higher capital requirements could probably accomplish as much as capping their size, without the potential downside for U.S. global competitiveness.

That leaves the third approach, which is embodied in the bill drafted by Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.): to establish an executive-branch resolution process for systemically important firms that is separate from bankruptcy and therefore allows officials to move swiftly to resolve a troubled institution in a crisis. The goal is not the lofty, but probably unrealistic, one of eliminating bailouts forever, but to structure the process so as to minimize both the frequency and scale of bailouts.

By wiping out shareholder equity and ousting management, the bill goes a good distance in that direction. But it could do more to eliminate moral hazard. Specifically, the bill would create a $50 billion fund, paid for by assessments on large banks, to resolve a failed firm. It promises, but does not quite guarantee, that creditors could never fare better than they would have in bankruptcy. The net result is that creditors might still be encouraged to provide the megabanks artificially advantageous terms, enabling them to grow bigger and take on more risk than they otherwise would.

Better to eliminate the $50 billion prepaid fund, which gives market players unhealthy confidence in an eventual bailout, and instead assess financial firms for the costs of resolution after the fact. This gives all of them an incentive to avoid trouble so that they'd never have to pay the assessment in the first place. The bill also should toughen its language on creditors, so that they know for certain that a bankruptcy-like payout is the most they can hope for. Based on our reading of the bill that emerged from Mr. Dodd's committee, a bipartisan compromise on these points is well within reach. That is, unless Democrats and Republicans are more interested in scoring political points than fashioning policy.

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