Is the Resolution Authority Enough in the Current Version of the Dodd Bill?

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In an April 7th, Wall Street Journal Opinion piece, authors Peter Wallison and David Skeel argue that the current version of the Senate bill should be opposed because "the simplest and clearest (reason) is that the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution." (see the full article in the Wall Street Journal.)

While we don't have to throw the baby out with the bathwater, their point is well taken. While there are important positive changes in the Dodd bill versus the House version vis a vis orderly liquidiation of failing financial firms, it is still in effect an FDIC-like process. There is a real issue whether the systemic risk of large, complex financial institutions can be managed in that environment. How do we deal with the clearing of positions in the OTC market? What happens to unsecured debt that might lead to runs on other institutions - foreign deposits, intrebank loans, repo financing, etc...? It seems to me that without well-defined rules the likelihood of some type of a bailout of non-insured deposits is quite high. And without the creditors having to pay, ex ante we lose market discipline, and we are back to square one.

In the NYU Stern book ("Regulating Wall Street: The New Architecture for Global Finance") we have a chapter titled, "Resolution Authority" (joint with Viral Acharya, Barry Adler and Nouriel Roubini). In this chapter, we discuss ways to address the above concerns of a FDIC-like receivership. But when push comes to shove, perhaps the only credible way to handle the failure of a large financial firm is to create a true Living Will or "resolution regime" for bankrupt financial firms which essentially converts each liability on a pre-defined basis into shares of the firm when the firm fails (a debt into equity conversion). The most risky and most junior liabilities get converted first, the least risky last. This way, large financial firms avoid the catastrophic costs of bankruptcy, yet creditors (and not taxpayers) bear the costs of failure. This provides creditors an incentive to impose market discipline, and therefore mitigating moral hazard.

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About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

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