A Regulator Serious About Reform

Jan 25 2012 - 6:31pm

Everyone likes to dump on regulators and government employees.  It's a regrettable, but favorite pass time of too many people, especially those running for office and running against Washington. Maybe time-honored, but destructive and often just dead wrong.

An example of this was yesterday when the FDIC held it's second meeting of the Systemic Resolution Advisory Committee, created by former Chairman Shelia Bair and now chaired by Acting Chairman Marty Gruenberg.  This meeting was was a rare, maybe unprecedented, event in Washington DC.  The Committee is comprised of 19 experts (academics, regulators, industry representatives) that come at financial reform and regulation from many different perspectives: from the President of Standard & Poor's, the COO of DTCC and the lawyer to all of Wall Street and beyond from Sullivan & Cromwell Rodgin Cohen to industry nemesis Professors Anat Admati and Simon Johnson and former Fed Chairman Paul Volcker. 

What was remarkable about this meeting (like its inaugural meeting) was that some of the most senior FDIC staff responsible for implementing some of the most important parts of the Dodd Frank financial reform law made presentations to the Committee for the purpose of questions and discussion.  This was all done for more than six hours in an open meeting at which the public and press were invited and which was live webcast (and video remains available on the website). 

The topic presented and discussed couldn't be more important: the orderly liquidation of systemically important financial companies, so-called SIFIs.  (The Agenda is available here.)  In particular, the FDIC is responsible for liquidating systemically significant companies that are failing and that threaten the financial system or the economy if, but only if, they have not been resolved by themselves or other regulators first.  It is important to understand that the resolution of such a company by the FDIC means breaking it up, although in an orderly fashion to eliminate or limit the damage to the system and the economy. 

This is a last resort power.  Systemically significant companies are never supposed to get to this point.  They are supposed to have their own resolution plans, so called living wills, that would enable them to prevent failure much earlier.  This self-resolution planning is to be enforced by the Fed, FSOC and other regulators.  This self-resolution planning is also supposed to be buttressed by other regulations designed to prevent failure, crisis, or distress in the first place.  That is why, for example, systemically significant companies are required to reduce their debt funding and increase their equity (so-called capital cushions) and why regulators can apply other enhanced supervisory and prudential standards.

Such pre-failure planning and risk-reduction measures, including regulator-required disposition of risky business lines, should enable even systemically important financial institutions to fail and file for bankruptcy without bringing down the entire system.  If they cannot file for bankruptcy without creating financial instability, due to market conditions or other circumstances at the time of failure, the FDIC, via FSOC, has the orderly liquidation authority to break up those institutions outside of bankruptcy, but in a manner that protects the financial system.

Along with other provisions of the Dodd Frank financial reform law (like much greater transparency and regulation of derivatives), these measures are all designed to prevent systemically significant companies from a disorderly failure like Lehman Brothers.  In short, these measures are supposed to prevent a repeat of the financial crisis of 2008 or something even worse.

However, many, including the biggest banks, the Wall Street crowd, their cheerleaders and enablers don't actually believe that the regulators are serious about such rules or, even if they are, that they will be able to implement them during a crisis.  Their intent and ability is questioned by the banks and bankers who benefit from being systemically significant and have a vested interest in such rules not working or being perceived not to work.  No matter what they say, they still believe (hope?) that they pose such a threat to the financial system that, just like last time, the government will bail them out with taxpayer money and they get to continue to play the rigged game of taking the upside of their recklessness and sticking the taxpayers with any losses. 

The FDIC Committee and its meetings are aimed directly at that crowd and that thinking.  One may hope that the FDIC won't have the ability or will to liquidate a mega-financial institution in a time of crisis, but it won't be because they failed to plan.  Not only has the FDIC planned extensively, but they are confident enough to publicly subject that planning to scrutiny by experts and, indeed, the world. (Keeping in mind that financial reform is still in the early stages of getting these regulations finalized and implemented, so that what the world sees isn't a fully formed, perfect, criticism-free plan, but one that is pretty far along, that asks the right questions and decidedly moving in the right direction.)

Self-interested hopes aside, this should send an unmistakable signal to the financial industry, the markets, the mega-banks and their many advisers that not only is liquidation authority being taken seriously, but it going to be a real option.  That is critically important because, ultimately, only market discipline will bring too-big-to-fail institutions into line and that depends on the market believing that the mega-banks can and will fail or, if that is too disruptive, that the regulators will use their orderly liquidation authority to break them up anyway. 

Interestingly, a real, robust and effective FDIC liquidation authority will makes its use much less likely.  If the biggest banks really believe that the FDIC can and will break them up in times of distress, then the greater their incentive to make sure that they never get to that point.  Non-FDIC regulators, like the Fed, Treasury and FSOC, must use this ultimate threat to make sure those banks have meaningful, complete and current living wills and they must put tough enhanced supervisory and prudential measures into place to ensure that bankruptcy or pre-liquidation measures will be effective.

One final note.  Public airing of hard thinking, challenging questioning and disagreement by serious people of good faith are so very important – but virtually always absent – to good policy that it cannot be overstated.  If such activities were done more broadly and more often, it would undoubtedly help restore some faith in government and the people who work in government. 

The FDIC's Systemic Resolution Committee is a great public service and other regulatory agencies like the Federal Reserve Board, the Financial Stability Oversight Council and the Treasury should also form similar committees and have similar open meeting discussions.  This would be good for them, good for the public, good for the financial industry and good for financial reform and stability.