After the Fall: A New Framework To Regulate “Too Big to Fail” Nonbank Financial Institutions

Alison M. Hashmall

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This Editorial summarizes my forthcoming Note, 85 N.Y.U. L. REV. (forthcoming June 2010), in which I assert that our current regulatory structure is suboptimal in its regulation of the systemic risk created by the failure of large, interconnected “nonbank” financial institutions (in general, a nonbank financial institution is any institution that performs financial functions but that is not legally a “bank” or depository institution) and that a different regulatory structure could do a better job of reducing systemic risk while minimizing the attendant moral hazard and uncertainty caused by current regulations. By pinpointing and examining the strengths and weaknesses of the Obama administration’s proposal for financial regulatory reform,1 I formulate a framework that will contain the systemic risk and reduce the uncertainty caused by current regulations without increasing moral hazard.


I.
Theory of Financial Institution Failure

In recent years, it has become apparent that the failure of large, interconnected nonbank financial institutions, such as hedge funds and investment banks, can create substantial systemic risk and thereby impose external costs on the financial markets and economy.2 Because no financial institution has the incentive to limit its own systemic risk,3 and because collective action by market participants to prevent systemic risk is unlikely,4 some regulation is needed to minimize the external costs produced by the failure of “too big to fail” (TBTF) institutions. Any remedial regulation should (1) prevent overly risky behavior by a TBTF institution that could cause it to fail and create contagion,5 and (2) prevent the panic among investors that can precipitate an institutional failure.

Regulation to avert systemic risk, however, can also create moral hazard and uncertainty. One way of reducing systemic risk is by “bailing out” TBTF institutions—guaranteeing their agreements with creditors and counterparties—which reduces the chances of their failure by preventing runs on the institutions. The problem with this approach, however, is that while loss-fearing counterparties and creditors normally exert market discipline to prevent institutions from taking on excessive risk, parties that come to expect future bailouts reduce their discipline accordingly. A policy of “constructive ambiguity”—only bailing out some creditors and counterparties so that none can count on a bailout ex ante—reduces this moral hazard. But constructive ambiguity also creates uncertainty in financial markets, leading panicked investors to withdraw their funds en masse from other financial institutions, which can increase systemic risk. The benefits of constructive ambiguity in reducing moral hazard will be produced most effectively through a discretionary and transparent process that retains uncertainty over the outcome of regulatory decision-making with regard to bailouts, but involves less ambiguity over the rules and process informing such decision-making. Creating clear procedures but preserving uncertainty over the outcome of a regulatory decision produces a better balance between uncertainty and moral hazard: Clear procedures will calm panicky investors, while uncertain outcomes will curb moral hazard.


II.
Evaluating Our Current Regulatory System

Our current regulatory system is suboptimal in both its ex ante and ex post regulation of systemic risk. Ex ante, the system fails to reduce the external costs caused by the overly risky behavior of nonbank financial institutions. Prudential regulations to curb such behavior are either insufficient, as with the Securities and Exchange Commission’s regulation of investment banks through the Consolidated Supervised Entities program, or nonexistent with respect to certain financial institutions, such as hedge funds. Ex post, the system does not sufficiently reduce the systemic risk caused by the failure of nonbank financial institutions and does an inadequate job of limiting the moral hazard and uncertainty that regulation creates. Under our current regulatory framework, when a large nonbank financial institution is on the verge of failure, regulators have two options: either undertake last minute, ad hoc actions to rescue the institution or permit the institution to file for bankruptcy. The problem is that this ad hoc approach can result in (1) bankruptcy filings by TBTF institutions that will likely cause contagion, as exemplified by the failure of Lehman Brothers, and (2) uncertainty in regulators’ decision-making processes that can create panic and worsen an ongoing financial crisis, also apparent during the aftermath of Lehman Brothers’ bankruptcy filing.


III.
The Obama Administration’s Framework for Regulatory Reform

The Obama administration’s proposed legislation would establish rules by which the Federal Reserve would designate certain financial institutions as TBTF—or Tier 1 financial holding companies (Tier 1 FHCs)—which would become subject to more stringent ex ante prudential regulations. The determination of whether an institution should be deemed a Tier 1 FHC would not depend upon the legal status of the institution, such as whether it is legally a bank, a hedge fund, or an investment bank, but rather on the extent to which a failure would be likely to impose external costs on financial markets and the economy. The Obama administration’s proposal retains the current bankruptcy process but adds a resolution regime that governs the failure of Tier 1 FHCs in some circumstances in order “to efficiently and equitably resolve the claims of creditors and other stakeholders”6 through a legal process similar to bankruptcy. Although the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) must approve a decision to invoke the resolution regime by a two-thirds vote, the Treasury would ultimately decide whether to invoke the regime upon consultation with the President.

The Obama administration’s proposal improves upon our current regulatory system, but it could do more to avert the systemic risk that could result from the failure of a Tier 1 FHC. Although the proposed framework instructs the regulatory agencies to consider “serious adverse effects” on the financial system and economy when deciding whether to invoke the resolution authority, the procedures for reaching such a determination are so stringent—requiring near consensus among numerous regulatory agencies—that it seems likely that at least some financial institutions whose failure will cause systemic risk will not be bailed out. The proposed legislation also leaves open the possibility that regulators, at the eleventh hour, might elevate moral hazard concerns above concerns about systemic risk. Furthermore, giving the Treasury—an agency firmly within the Executive branch—the ultimate authority to invoke the resolution regime overly politicizes what should be a technical decision based on an assessment of the expected systemic cost.

I also contend that the proposal fails to sufficiently reduce uncertainty in policymaking decisions, which could trigger panic and contribute to an environment where short-term creditors are likely to run a Tier 1 FHC. First, because the proposal leaves open the possibility of bankruptcy, creditors and counterparties of the institution now must worry about their ability to recover if the institution fails under both bankruptcy law and resolution rules. Second, the legislation does not require regulators to disclose the basis for the decision of whether an institution’s failure creates “serious adverse effects.” Without transparency in this crucial determination, ambiguity over the decision-making process remains, creating additional uncertainty for investors.


IV.
An Alternative Regulatory Reform Framework

While the Obama administration’s proposal has clear benefits, I suggest modifying the proposal’s ex post process for resolving the failure of TBTF financial institutions in order to prevent systemic risk more effectively and to reduce uncertainty. I propose that the Federal Reserve be given unilateral power to authorize the FDIC to seize a failing institution and place a value on the expected cost to the financial system and the economy of the institution’s failure. A cost-benefit provision in the new statute would then require the FDIC to provide the institution with financing only up to the cost of the systemic risk created by that institution’s failure.7 This will ensure that the expected cost of any bailout is less than the expected cost of systemic effects. Under my proposal, institutions deemed to be Tier 1 FHCs would not be subject to the bankruptcy process.

This alternative regulatory framework will improve upon the administration’s proposal in three ways. First, it will prevent systemic risk more reliably without worsening moral hazard. The cost-benefit provision of the resolution process ensures that systemic risk is properly considered and prioritized ex post in resolving a Tier 1 FHC failure. Under my proposal, regulators would not be permitted to elevate concern about creating moral hazard above the problem of systemic risk when deciding whether to allow a failed institution to liquidate. Furthermore, even though it is more likely under my proposal than under the administration’s proposal that Tier 1 FHCs will be rescued to some extent, any moral hazard will be limited because only short-term creditors with high-priority claims against an institution, not long-term subordinated creditors, are likely to recover fully in a resolution process.

Second, the Federal Reserve, as a regulatory agency with substantial prior experience regulating large, complex financial institutions and as the agency that would be responsible for monitoring and regulating Tier 1 FHCs ex ante, would have the most expertise and independence to make sound technical determinations about whether the systemic risk exception should be invoked.

Third, this framework reduces the additional harm and contagion caused by uncertainty in regulatory behavior without losing the benefit of reduced moral hazard. By removing the possibility of bankruptcy, the framework I propose eliminates a layer of legal uncertainty that could contribute to panic and trigger a run on financial institutions. Requiring transparency in the Federal Reserve’s methodology for making a systemic risk determination also reduces the ambiguity in decision-making procedures that can exacerbate a financial crisis.

Acknowledgments:

Copyright © 2010 New York University Law Review.

Alison M. Hashmall is a J.D. Candidate at New York University School of Law.

This Editorial introduces and is an abbreviated version of Alison M. Hashmall, Note, After the Fall: A New Framework To Regulate “Too Big to Fail” Nonbank Financial Institutions, 85 N.Y.U. L. Rev. (forthcoming June 2010).

  1. I am referring to the Obama administration’s draft legislation and the associated White Paper introduced over the summer of 2009. Such legislation has changed shape as it progresses through the House and Senate. DEP’T OF THE TREASURY, FINANCIAL REGULATORY REFORM, A NEW FOUNDATION: REBUILDING FINANCIAL SUPERVISION AND RREGULATION 10–18 (2009), available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf (White Paper); DEP’T OF THE TREASURY, BANK HOLDING COMPANY MODERNIZATION ACT OF 2009, available at http://www.treasury.gov/press/releases/tg227.htm (follow “Title II” hyperlink at bottom of page) (draft legislation sent to Congress July 22, 2009); DEP’T OF THE TREASURY, RESOLUTION AUTHORITY FOR LARGE, INTERCONNECTED FINANCIAL COMPANIES ACT OF 2009, available at http://www.treasury.gov/press/releases/tg227.htm (follow “Title XII” hyperlink at bottom of page) (same).
  2. Professor Schwarcz defines systemic risk as “the risk that (i) an economic shock such as market or institutional failure triggers . . . either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability . . . .” Steven L. Schwarcz, Systemic Risk, 97 GEO. L.J. 193, 204 (2008).
  3. PRESIDENT’S WORKING GROUP ON FIN. MKTS., HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 31 (1999) (“Every firm has an incentive to restrain its risk taking in order to protect its capital, and firm managers have an incentive to protect their own investments in the firm,” but “{n}o firm . . . has an incentive to limit its risk taking in order to reduce the danger of contagion for other firms.”).
  4. Market participants are unlikely to solve market failure by collective action because “the externalities of systemic failure include social costs that can extend far beyond market participants.” Schwarcz, supra note 4, at 206.
  5. Contagion occurs when the failure of one financial institution causes a domino effect of failures of or losses in other similar institutions.
  6. Robert R. Bliss & George G. Kaufman, U.S. Corporate and Bank Insolvency Regimes: A Comparison and Evaluation, 2 VA. L. & BUS. REV. 143, 144 (2007).
  7. The application of a cost-benefit analysis would be mandated by statute, but the Federal Reserve would develop the process for such an analysis in more detail through regulation.

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