David Zaring, a Lack of Resolution
| Publication year | 2010 |
A LACK OF RESOLUTION
David Zaring*
[T]here is a clear need for a new "resolution authority."
-Paul A. Volcker1
How few there are who have courage enough to own their Faults, or resolution enough to mend them!
-Benjamin Franklin2
ABSTRACT
The failure to resolve-that is, impose a quick death penalty on-enormous financial intermediaries such as Lehman Brothers and AIG damaged the ability of the government to respond to the financial crisis. But expanding resolution authority to cover new systemically significant institutions-which is one of the lynchpins of financial regulatory reform-poses a problem of legitimacy with constitutional implications, as resolution authority is usually exercised with almost no predeprivation process and little postdeprivation compensation. At the same time, banking regulators have failed, every time they have been given more resolution authority, to exercise that authority when it is needed.
This Article reassesses resolution authority. It proposes (1) domestic solutions to protect against government overreach and (2) an international context to deal with the problem of underreach. First, it proposes that the government make an ex ante public list of potentially nationalizable institutions and, ex post, provide the owners of seized institutions a brief window in which to buy their institutions back from the regulators who took them. This proposal would add both a process check and a market check to this most severe form of decisionmaking. At the same time, this Article also proposes internationalizing the context of the decision to use resolution authority by including expert multinational committees of regulators in the decision. Because these regulators are somewhat insulated from ordinary domestic politics, this twofold approach is more likely to encourage the appropriate resolution of the largest institutions than any solely domestic approach.
INTRODUCTION ................................................................................................ 99
I. THE CURRENT LACK OF RESOLUTION ................................................ 109
A. Existing Resolution Authority and the Financial Crisis ............. 109
1. A Brief History of Resolution Authority ............................... 110
2. Resolution Authority and the Financial Crisis ..................... 117
B. The Dodd-Frank Approach ........................................................ 121
1. Broader Authority, More Sign-Offs ...................................... 122
2. How Broad Is Broad? ........................................................... 125
3. Living Wills .......................................................................... 127
II. ANTI-SEIZURE PROTECTIONS FOR FINANCIAL INSTITUTIONS ............. 129
A. Takings ....................................................................................... 131
B. Due Process ................................................................................ 134
C. Bias ............................................................................................. 137
III. CONSTITUTIONAL, AND EXERCISABLE, RESOLUTION AUTHORITY ..... 138
A. Protection Against Government Overreach ............................... 139
1. Making a List ........................................................................ 141
2. The Market Out .................................................................... 143
B. Prevention from Underreach ...................................................... 145
1. International Nature of the Problem ..................................... 147
2. Capacity of the International System .................................... 150
3. Operation of an International Approach............................... 152
4. Theory and Alternatives ....................................................... 154
CONCLUSION .................................................................................................. 156
INTRODUCTION
The Supreme Court has regulated the government's "power to destroy" since 1819.3But Congress and the Constitution have protected the interests of the insolvent by permitting them fresh starts and granting them a variety of rights through bankruptcy for even longer.4Because debtor protection goes hand in hand with the destruction of the interests of creditors, the fresh start and the power to destroy have been on uneasy terms ever since.
Consider the fate of big, struggling financial intermediaries like the Lehman Brothers and AIGs of the most recent financial crisis. During that crisis, these institutions all but collapsed, at tremendous economic cost. They could have been destroyed, or the government could have saved them or given them some other sort of fresh start. This sort of fresh start might have been accomplished by invoking its resolution authority. Resolution authority is the polite term for seizing failing financial institutions and either shutting them down or selling them off for the best possible price. Resolution is meant to be implemented before contagion sets in and the institutions' counterparties, including customers, traders, and even competitors, also fail, either through panic (which is not the fault of the counterparties) or poor risk management (which is, but still may exacerbate a crisis). It is a particular kind of instant bankruptcy, destroying the interests of some creditors quickly and unmercifully, while giving others, especially the bank's depositors, a fresh and happy start.
Well-deployed resolution authority could mean that financial cataclysms of the sort threatened by Lehman and AIG would not bother ordinary Americans; their banking needs would be unaffected by the occasional smoothly resolved collapse of an institution in which they may have placed their trust, along with a dollop of high-quality deposit insurance.5It might, at least in theory, stop financial crises before they start.
However, neither Lehman nor AIG were subjected to this sort of discipline. Was that lack of resolution the reason why the financial crisis was so severe?
Congress and President Obama seem to think so, and in the wake of the crisis, they have passed and signed legislation designed to enhance and broaden the government's power to destroy through resolution. Properly conceived, resolution authority looks like a valuable exercise of government power, and it is a cornerstone of the government's ongoing efforts to keep the financial system stable.6But it is not a panacea, and this Article explores its problems in the context of the other ways that the government can exercise the power to destroy and the power to grant a fresh start.
Resolution authority's problems are twofold. The first is that it is a power to destroy par excellence, and those sorts of powers need to be limited-a need particularly worth considering at a time when Congress has dramatically expanded the government's resolution authority through the Dodd-Frank Act reforming financial regulation. The second is that the government, perhaps aware of the dramatic nature of the act, has proven to be loath to exercise its power to destroy. This Article proposes an approach that would deal with both problems, one that differs from the new sort of authority promulgated by Congress in Dodd-Frank. It suggests a way to cabin the power to destroy and a way to ensure that the government exercises that power when it should.
Getting resolution right is worth doing; we will have another financial crisis, and soon. The World Bank has identified 112 episodes of systemic banking crises in 93 countries since the 1970s, and American banking crises appear to come along once every decade or so.7These crises all feature institutions that go bust seemingly overnight, all calling for resolution, bankruptcy, or a bailout.
And the alternative to resolution reform-which in the United States amounts to unclear resolution authority with inadequate encouragement of its use-is an unhappy one. During the last financial crisis, the government occasionally exhibited what the shareholders of Washington Mutual, the largest thrift8in the country at the time, thought was a lack of control, demonstrated by the government's seizing and resolving a bank when a strong case could be made for its continued solvency.9
But mostly, it evinced what we might call a lack of resolution. In some cases the government organized deals, on the fly, to handle insolvency, as when the Federal Reserve and the Treasury Department forced the sale of one investment bank that they did not regulate-Bear Stearns-to a commercial bank,10despite a lack of obvious authority to intervene in investment banking and through some rather extraordinary cajoling and fundraising.11It did not resolve this institution.
Sometimes the government simply bailed out the insolvent institution. It did so for the credit default swap titan AIG, which it also did not resolve.12
And it both bailed out and seized the big secondary mortgage market makers Fannie Mae and Freddie Mac, placing both institutions under government receiverships while taking over their massive debt burdens.13The government also bailed out most of the other large players in the financial system even before figuring out whether they were solvent or not.14Those bailouts, of course, were unpopular and expensive propositions for the taxpayers,15which makes it all the more confusing that, as Federal Reserve Governor Daniel K. Tarullo has observed, the government in most cases (but not for Washington Mutual, Lehman Brothers, and Bear Stearns) "selected the bailout option" in lieu of bankruptcy or resolution.16
Legal constraints may have played a role in what the government did, not that the basis for its financial sector choices was ever entirely clear. The government might have suspected, for example, that the failure of Lehman Brothers could be catastrophic, but concluded that it was powerless to save the investment bank because Lehman was structured not as a "bank," but as an institution...
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