Raj Date on Resolution Authority, Conservative Arguments on Bailouts

.1.3 Removing moral hazard

The mere existence of a special resolution regime for certain large firms, and not others, could in theory create its own difficulties. Orderly liquidation almost certainly preserves more franchise value than an uncontrolled de-leveraging followed by bankruptcy. Absent counter-measures, that would create a perverse preference by creditors to lend to the largest and most systemically risky firms, like Goldman, as opposed to smaller rivals.

In light of that risk, the Senate Bill crafts a strikingly punitive resolution regime. The Bill requires that the FDIC, as receiver, act “not for the purpose of preserving the covered financial company”; ensure that shareholders are paid only after all other claims are paid; require that unsecured creditors bear losses; and terminate “management responsible for the failed condition”.

Crucially, the Bill also sets out a cap on the amount that a creditor can receive from the resolution of a systemically important firm. No creditor can receive more than it would have received in a regular-way chapter 7 bankruptcy liquidation.(23) Creditors cannot be better off because of the existence of the resolution authority. Thus, the Bill effectively severs the potential feedback loop from the existence of a special resolution regime to moral hazard among creditors.

(23) – Id. at section 210(d)(2). Note that this maximum recovery also serves as a minimum recovery in those instances that the FDIC wishes to use its discretion to pay certain creditors more than similarly situated creditors, to minimize aggregate losses. In other words, the FDIC can preferentially pay a creditor, but only if similarly situated creditors are at least receiving what they would have received in a chapter 7 bankruptcy. Id. at section 210(b)(4)(B).

The repayment waterfall specifies that taxpayer money has to get returned before creditors get paid. If some creditors are paid more than similarly situated peers it can only occur if those peers get at least what they would have gotten in liquidation which occurs only if, by definition, the FDIC has already gotten its money back too. Not a bailout.

And as Raj points out in his conclusion, the real worry is twofold – that Federal Reserve expanded access to healthy firms in a crisis will disproportionately benefit larger and riskier firms, and that regulatory forbearance (that regulators will not want to pull the trigger to close a firm that is gigantic and has a huge political presence) hasn’t really been solved by this bill. These are the real problems outstanding with the current sense of resolution authority.