William C. Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, spoke at the Global Economic Policy Forum and focused on options and resolutions to end “too big to fail” financial institutions.
Mr. Dudley began by explaining that too big to fail is unacceptable in multiple respects. The first problem, Mr. Dudley observed, is that it creates an uneven playing field between large and small financial firms, leading to a funding advantage because too big to fail financial institutions are all but guaranteed a bailout. This notion in turn creates incentives for financial firms to become bigger and more complex, thereby leading to even more systematically important financial institutions and the exposure of America’s financial and economic stability to greater risk.
In order to solve too big to fail, Mr. Dudley made two suggestions: (i) make the financial system more stable by reducing the degree of disruption that results when failures occur, thereby lowering the risk of a failure in the first place, and (ii) eliminate the artificial advantages that large, complex firms “might have” which create incentives to become bigger and more complex. In order to reduce the consequence of failure, Mr. Dudley noted, considerable effort has been made to create incentives for firms to standardize the over-the-counter derivative trades and clear those trades through central counterparties.
Another solution Mr. Dudley endorsed is the single point of entry framework for resolution proposed by the Federal Deposit Insurance Corporation (“FDIC”). Mr. Dudley explained that, under this framework, if a financial firm is to be resolved under Dodd-Frank Title II (“Orderly Liquidation Authority”), the FDIC will place the top-tier holding company into receivership and its assets will be transferred to a bridge holding company. The equity holders will be whipped out and long-term unsecured debt converted into equity in the bridge company to cover any remaining losses and ensure that the bridge company is adequately capitalized and creditworthy. Under this system, Mr. Dudley notes, subsidiaries would continue to run in order to reduce consumer banking stress.
To lessen the probability of default, Mr. Dudley mentioned a number of steps which can be taken to reduce the likelihood of failure, including the new Basel III framework. Mr. Dudley explained that a key step in reducing the opportunity for failure is for regulators to create incentives for bank management to act before government intervention is necessary. Early resolution can take many forms, Mr. Dudley said, including cutting capital distribution earlier, raising new capital faster, restricting business sooner, and making swift executive management and board changes when a firm is not performing well.
Mr. Dudley expressed his skepticism about certain solutions when dealing with too big to fail. He explained that imposing size limits is not an efficient means of making the financial system more stable, and could sacrifice beneficial economics of scale and scope. Additionally, he noted that the cost of breaking up financial institutions is a significant deterrent. In closing, Mr. Dudley stated that, until Title II resolution is used, there will remain uncertainties as to how well regulators can end too big to fail.
Lofchie Comment: While I understand the theoretical appeal of the notion that the standardization of derivatives contracts under Title VII of Dodd-Frank could result in more entrants in the derivatives markets, thus reducing the size or importance of the major players, my guess would be that, in actual practice, the result would be the opposite. That is, I would guess that the tremendous costs of regulation under Title VII, including all of the new required technology, impose such high fixed costs on derivatives dealers that small and medium firms are either driven from the market entirely or else keep their activities at a level below that which would require them to register as swap dealers. As a result, we end up with the worst of both worlds: (i) standardized products that cannot be readily tailored to the hedging needs of individual users; and (ii) heavy fixed costs that drive concentration to the largest firms most able to bear these fixed costs.
Of course, my guess is just a guess. This is an important question that should be very easy to test empirically, given the tremendous amount of information that the CFTC is now collecting with regard to the swaps markets.