BEYOND BANKRUPTCY: RESOLUTION AS A MACROPRUDENTIAL REGULATORY TOOL.

• Author: Schwarcz, Steven L.

INTRODUCTION 710 I. TYPOLOGY OF RESOLUTION-BASED REGULATION 716 A. Reactive Resolution 716 1. Applying Reactive Resolution Directly to Systemically 716 Important Firms 2. Applying Reactive Resolution Indirectly to Systemically 720 Important Firms B. Proactive Resolution 721 1. Converting Debt to Equity 722 2. Resolving the Corporate Structure 724 3. Last-Resort Lending 726 C. Counteractive Resolution 727 II. IDENTIFYING RESOLUTION'S MACROPRUDENTIAL GOALS 728 A. Resolution Should Protect Systemically Important Firms 728 both Individually and Collectively B. Resolution Should Also Protect Systemically Important 730 Markets and Infrastructure III. DESIGNING RESOLUTION-BASED REGULATION TO ACHIEVE THOSE GOALS 734 A. Resolution-Based Regulation of Systemically Important 734 Firms 1. Reactive Resolution 734 2. Proactive Resolution 736 B. Resolution-Based Regulation of Systemically Important 739 Markets 1. Reactive Resolution 739 2. Proactive Resolution 739 C. Resolution-Based Regulation of Systemically Important 741 Infrastructure 1. Reactive Resolution 741 2. Proactive Resolution 742 CONCLUSION 746 APPENDIX 748 A. Regulatory Design Recommendations 748 1. Resolution-Based Regulation of Systemically Important 748 Firms 2. Resolution-Based Regulation of Systemically Important 749 Financial Markets 3. Resolution-Based Regulation of Systemically Important 749 Financial Infrastructure INTRODUCTION

Since the global financial crisis of 2008 and 2009 (the "financial crisis"), regulators and policymakers have been shifting their focus from traditional microprudential regulation, which protects individual banks and other financial firms, (1) to "macroprudential" regulation that protects the stability of the financial system itself. (2) Because macroprudential regulation is still very much in the process of developing, (3) its specific measures are viewed as "tools" in a regulatory "toolkit." (4)

In designing macroprudential regulation, regulators originally focused on trying to deter events that might trigger financial destabilization. (5) It is not always clear, however, what those events are or how they could be deterred. (6) For example, the Dodd-Frank Act seeks to dampen overheated mortgage lending, one of the events that triggered the financial crisis. (7) But mortgage lending is unlikely to be a trigger of the next crisis; each financial crisis is different from the last and raises new issues. (8)

Likewise, current regulatory efforts to deter excessive risk-taking by systemically important financial firms ("systemically important firms") (9) are questionable. Although that risk-taking was a trigger of the financial crisis (10) and appears to be a continuing threat to financial stability, (11) regulators remain uncertain how to control it. (12) Their deterrent efforts focus on politically appealing factors such as reducing moral hazard and aligning managerial and investor interests. (13) But attributing excessive risk-taking to moral hazard is unsupported by hard evidence and inconsistent with management incentives; (14) and aligning managerial and investor interests ignores that excessive risk-taking is primarily motivated by a different misalignment--between managerial and investor interests, on the one hand, and the interests of the public, on the other. (15)

Frustrated that they "have made little progress in figuring out how they might actually" prevent another financial crisis, (16) regulators have been expanding their macroprudential focus to include bankruptcy "resolution" techniques designed to reorganize the capital structure of, (17) or else to liquidate with minimal systemic impact, systemically important firms that become financially troubled. (18) To date, however, regulatory efforts to use those techniques to try to protect financial stability have been inadequate, (19) in part because bankruptcy law (20) traditionally has microprudential goals--to protect individual firms that are financially troubled but otherwise viable (21)--whereas rent thinking about using bankruptcy-resolution techniques for macroprudential purposes conflates these goals.

For example, it is commonly assumed that applying bankruptcy-resolution techniques to protect individual systemically important firms will protect all systemically important firms and thereby increase financial stability. (23) Regulation based on that assumption, however, can overlook correlations among systemically important firms (24) and can sometimes even reduce financial stability. (25) Many also believe that bankruptcy law itself should be amended to better adapt it to the resolution of systemically important firms, but that would still be microprudential, designed to protect individual firms rather than the financial system. (26) Even the Dodd-Frank Act's Orderly Liquidation Authority, which applies bank receivership to resolving nonbank systemically important firms, is inherently microprudential. (27)

These flaws illustrate the need to more carefully and critically analyze the macroprudential goals of resolution in order to differentiate them from microprudential goals and derive a logically consistent theory of how and why macroprudential resolution-based regulation ("resolution-based regulation") (28) can help to stabilize the financial system. This Article begins that analysis, laying the groundwork in Part I by examining how resolution-based regulation is being (or contemplated to be) used and explaining why that use may be insufficient.

Part II then identifies the macroprudential goals of resolution-based regulation. It argues that such regulation should be used to protect systemically important firms not merely individually but also collectively. It also observes that the existing resolution-based regulatory focus on troubled systemically important firms obscures the importance of additionally using resolution-based regulation to protect other critical elements of the financial system whose failure could trigger a systemic collapse--the markets in which securities and other financial assets are traded, and the financial infrastructure that serves to clear and settle that trading. (29)

Part III analyzes how to design resolution-based regulation to achieve those goals, (30) using insights gleaned from recognizing that the financial system is a "system." Systems that are both interactively complex and tightly coupled are prone to catastrophic failure, suggesting that resolution-based regulation should be designed to reduce tight coupling and/or interactive complexity. To this end, Section III.A argues for resolution-based regulation that would reduce interactive complexity by requiring systemically important firms to disclose more detailed information about their securities holdings and contractual obligations. Section III.B explains how resolution-based regulation could reduce tight coupling by authorizing central bank last-resort lending to protect illiquid but solvent systemically important firms (31) as well as to prevent financial market panics.

Finally, Section III.C explains how resolution-based regulation could protect the financial infrastructure, which is operated by clearinghouses and central counterparties. Although private organizations and regulators have been considering how the equivalent of resolution-based solutions could protect central counterparties, they have largely neglected the need to protect clearinghouses that are part of a holding company structure that exposes them to financial and operating risks of affiliates. This Section shows how resolution-based regulation could use ring-fencing to protect against those risks, including by making the clearinghouse bankruptcy-remote. It also explains, by analogy to laws ring-fencing public utilities, why clearinghouses should be ring-fenced: both provide essential public services, have few if any substitutes, and are exposed to affiliate risks.

The reader should note that this Article focuses on developing resolution-based regulation as an additional macroprudential "tool." (32) Except as specifically discussed, (33) the Article does not purport to critique, much less criticize, non-resolution-based macroprudential regulation. (34) Furthermore, the Article's analysis of the inadequacy of using bankruptcy-resolution techniques that have microprudential goals to try to protect financial stability, a macroprudential goal, is not intended to criticize microprudential resolution-based regulation. Such regulation has its own merits and can valuably complement macroprudential regulation. (35)

1. TYPOLOGY OF RESOLUTION-BASED REGULATION

   As a real-world foundation, first consider how resolution-based regulation is currently being used, or is contemplated to be used. This Article identifies three general approaches. (36) The first two approaches--"reactive" resolution and "proactive" resolution--represent resolution in the strict sense of reorganizing the capital structure of, or liquidating, a firm. (37) The third approach, "counteractive" resolution, represents regulation that is designed to reduce the need for resolution by mitigating the risk of failure. As such, it is not strictly resolution per se. For that reason, the Article focuses primarily on reactive and proactive resolution.

   1. Reactive Resolution

      Reactive resolution-based regulation ("reactive resolution") is by far the most common approach in the United States and worldwide. It is "reactive" in the sense that it applies if, and only if, a firm becomes financially troubled. For example, corporate bankruptcy law is designed to reorganize the capital structure of financially troubled firms to make them viable, and to liquidate such firms that cannot be made viable. (38) As next explained, reactive resolution is currently being applied both directly and indirectly to systemically important firms.

      1. Applying Reactive Resolution Directly to Systemically Important Firms

         In principle, reactive resolution can apply to any...