The Killer G’s:  Resolution Authority, Financial Stabilization, and Taxpayer Bailouts

Next week, the Senate will begin consideration of what could be a sweeping overhaul of financial market regulation.  One of the Senate Bill’s key objectives is to solve the “too big to fail” problem that plagued policy-makers in 2008.

To date, observers appear conflicted about whether the Bill succeeds or fails on that measure.  This research note informs the question, by (1) describing a taxonomy of too big to fail bailouts as manifested during this financial crisis; (2) evaluating whether the Senate Bill, if it had been in place several years ago, would have prevented any or all of those taxpayer-funded rescues; and (3) highlighting an important caveat for policy-makers.

The term “bailout”, as applied to the most recent crisis, refers to three distinct kinds of taxpayer-funded support for private enterprises:  “blank check” capital infusions and asset guarantees that supported all of a firm’s stakeholders, like the original TARP’s $10 billion capital infusion into Goldman Sachs; “deathbed conversions” of non-banks into regulated bank holding companies, like the hurried transformation of GMAC; and “last resort liquidity” programs to alleviate the broad-based funding crunch, like the FDIC’s guarantee of more than $50 billion of GE Capital’s unsecured debt.

The too big to fail problem manifests itself in all three categories of bailouts.  As currently drafted, the Senate Bill dramatically reduces the problem posed by the first two, and makes some progress with respect to the third.

The “blank check” bailout is, in large measure, eliminated by the plain terms of the Bill’s resolution authority.  Crucially, systemically important firms’ shareholders, creditors, and managers cannot wind up better off under the Bill’s resolution authority than they would have under a regular-way bankruptcy liquidation.  Neither the pre-existence nor size of a resolution fund alters this fundamental point.

Moreover, because the Bill contemplates heightened prudential standards for even shadow banks that are systemically important, the prospect of moral hazard-inducing “deathbed conversions” is diminished. 

The Bill could be stronger with respect to “last resort liquidity”, particularly if policy-makers are concerned about generally available liquidity facilities that disproportionately benefit the largest firms.  The Bill might, for example, provide a fast-track legislative check on the Fed’s emergency lending discretion, or inflict greater shareholder pain on a systemically important firm that avails itself of Fed- or FDIC-supplied emergency liquidity support. 

The Senate Bill, then, takes a broadly sound approach to ending the too big to fail problem, with a few areas for tactical improvement.  Policy-makers should recognize, though, that the power of the Bill’s approach could be eroded by systematic regulatory capture or inattention, particularly at the Federal Reserve.