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More on the Resolution Authority Headfake

Self-deception is a remarkably useful form of mental disturbance. Calculated liars have to keep their stories straight, while the deluded are sincere and often unshakable in their misguided beliefs.

The Powers That Be insist that a magic bullet called a special resolution authority will solve many of the problems with the “heads I win, tails you lose” taxpayer backstopped financial system with inadequate oversight. The prospect of taking terminally sick banks out and shooting them will supposedly reintroduce moral hazard and make banks behave responsibly again.

The problem is that there isn’t much evidence to support this optimistic belief. Investment banks were seen as normal enterprises, at risk of bankruptcy, before the meltdown, yet that did not prevent Bear, Lehman, and Merrill from getting themselves into trouble that ultimately proved fatal. And the leaders of these enterprises did not take meaningful financial hits (oh yes, they were less rich than they would have been otherwise, but none of them is at risk of spending his waning years subsisting on dog food), a lesson surely not lost on other bank CEOs.

Then we have the wee problem that the idea of a special resolution authority looks not credible. We’ve harped more than once that as long as the firms crucial to debt markets remain deeply connected to each other, the idea that one can be taken out gracefully without impacting the others is a fairy tale. We’ll believe this comforting story only if we see measures to cut back counterparty exposures, most importantly in the repo and credit default swaps markets.

Bob Teitelman, editor of The Deal, gives a more detailed evisceration of the problems with the idea (I’m jealous that I didn’t write this myself):

The absence of resolution authority has become as handy an excuse for the mess as any, like the lack of a League of Nations after World War I…..Resolution authority, in short, is the Maltese Falcon of regulatory reform. What is this strange bird? Simply put (though nothing here is simple), it’s the legislative authority to wind down a financial firm. In fact, this definition is about as far as anyone ever gets on the subject….In its grandiose form (as if its normal form isn’t ambitious enough), the mere presence of resolution authority will scare the crap out of stockholders, creditors and counterparties and make them do their job, which is insuring that banks don’t go all suicidal, blow themselves up and force regulators to do their jobs….

But something about resolution authority feels too good to be true. Resolution authority is modeled after the Federal Deposit Insurance Corp.’s power to deal with failing banks. That’s fine, but when was the last time the FDIC tackled a promiscuously interconnected, global, highly leveraged giant? Given that we seem to have no idea how finance is wired, how can we be sure that we can halt contagion from spreading from a firm rotting faster than a day-old corpse?….Resolution authority might even trigger self-fulfilling prophecies — setting off an early scramble for the exits, while regulators are still watching the feature. And what about overseas assets?….

Who believes that if Goldman, Sachs & Co. was flaming out, the feds would not flinch? Answer: no one with a measurable IQ. Resolution authority resembles proactive bubble defense: The optimal time to use it is before the anticipated corpse turns blue. But if Paulson had shuttered Lehman right after Bear collapsed, would he be praised, pilloried or prosecuted like a dog? Lehman would have howled, Congress would have whined, so try door No. 3. Resolution authority demands, well, resolution in the face of a spitting mob. And yeah, money; no free lunch here. To make it fly requires a hero — Volcker played that role once on inflation — willing to lose everything. Alas, such lunatics are rare, making resolution authority just a dusty prop from an old movie.

Yves here. Aside from pointing out the obvious, glaring operational issues, Teitelman points out that there is a massive political problem: for resolution authority to prevent contagion, the sick financial firm probably has to be taken out and shot relatively early. Look how quickly Bear went into a death spiral, a mere ten days. Paulson, who was famously aggressive (like it or not, it did take nerve to put Fannie and Freddie into conservatorship) stepped back on Lehman (this seems to have been in part collective frustration of the officialdom team when the Barclays rescue was blocked by the FSA, of having not been prepared for that deal to fail, but it was also clear at the time that Lehman was not going to be rescued, that the bad press on Bear meant the next firm that foundered would not be helped).

Remarkably, the often-sound Epicurean Dealmaker defends the fantasy resolution authority. And his choice of metaphor undermines his argument. He uses both a “break glass” emergency image and the same expression in the article. Surely he must recall the Neal Kashkari “break the glass” memo mentioned in Sorkin’s Too Big Too Fail. It was well received by the higher-ups and was totally useless in practice.

ED offers two defenses, that the vagueness give regulators flexibility and discretion. Ahem, regulators always have those available to them. And the powers that be had that in spades during the crisis. They went around and did rescues that were widely criticized for their inconsistency and ad-hoc-ness. Why were Bear’s shareholders given anything at all? Why were WaMu’s sub bond holders crammed down (and worse, as John Hempton bitterly argues, a bank that he believes was not insolvent taken out and shot?). In fact, that very “flexibilty” meant that the authorities seemed to be constantly overcorrecting in response to whatever criticism they had gotten on their most recent salvage operation.

“Flexibility and discretion” is merely putting a happy face on “we’re going to have to improvise our way through this one yet again.” Now a certain amount of improvisation is necessary (an old saying has it that no plan survives first contact with the enemy). But for an completely untested and untrusted regime, the authorities need to convey the ground rules and key mechanisms in advance, both to prepare investors and counterparties, and more important, to debug the plan on paper as much as possible in advance.

Another ED argument in favor of flexibility amounts to, “markets evolve too quickly, you can’t really plan.” I don’t buy that in the strong form version he presents. The Bank of England prepares a Financial Stability Report twice a year, and it very clearly identified the dangers that large complex financial institutions posed pre crisis, as well as the risks posed by key markets. Unfortunately, that analysis did not translate into the kind of preventive measures that might have been warranted (but the UK also has the problem of large domestic banks with large international exposures, which means that many of the risks were beyond the authorities’ ability to contain). This means that regulators need to be vigilant about the evolution of markets, monitor exposures aggressively, and update emergency plans frequently (at least annually, and in a fundamental rather than superficial manner).

Or it points to another approach. I am very skeptical that the financial system can be made less dangerous and costly to society as a whole absent root and branch reform, which means much more aggressive oversight, with the objective of regulating activities that are critical to advanced capitalist economies (namely, the credit markets infrastructure) like utilities (I discuss how to go about doing that longer-form in ECONNED). We clearly lack the political will to do so now. In the meantime we will be subjected to various reform proposals which leave the system which has enabled the financiers to loot taxpayers on an unheard-of scale intact.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

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