........Well, let’s start, first, with what should be the most basic test of any legislation: does it achieve the immediate goal it was designed to achieve? In this case, if you define “immediate goal” as “prevent a rerun of what happened after Lehman failed the next time a large institution blows up,” the answer is “no.” I’m not being hypothetical here. You can go back and walk through the process, and see what would have been happened.
Shall we? Lehman’s failure led to a general financial meltdown, you may recall, because a money market fund called the Reserve Fund owned a tiny piece of Lehman debt. When Lehman defaulted on that debt, Reserve broke the buck, which in turn caused panicked investors to pull out of money market funds en masse. As cash fled the funds, the commercial paper market (wherein MMFs are the main buyers) froze up. Voila! Suddenly a vast swath of corporate America, from General Electric on down, was on the verge of insolvency. It wasn’t until the FDIC stepped in and guaranteed money funds that catastrophe was averted.
OK, now to today. If we pretend the new bill were in place and a similar Lehman-style collapse happened, what would be different? Nothing. In their (entirely understandable) desire that the federal government not be seen as the final savior of every institution in the system, legislators are insisting that no institution is seen as “too big to fail.” So in the event of a troubled institution’s collapse, the feds will step in with “resolution authority” but will insist that equity and debt investors take their hits like grownups. Even, presumably, if the debt holder is a money market fund that will break the buck upon default, which in turn will cause panic among other money fund investors and then . . .
........In the meantime, this resolution authority that the Congress wants to confer on the federal government (which is supposed to take care of the TBTF problem, remember) is a disaster waiting to happen. Do you know how it’s supposed to work? In the event a financial institution runs into trouble, the federal government will have the power to unilaterally step in, take it over, and “wind it down”—that is, liquidate it. The firm’s shareholders will be wiped out; its debt will go into default. And the authority won’t apply just to chartered banks. The government will have the power to seize any institution it deems “systemically important.” Which is to say, it will be able to seize any company, anywhere.
You can see why this might be alarming. First off, and as noted, in the midst of a financial panic it’s not clear what good resolution authority will actually do. But it’s not hard to imagine the mischief—and not just during panics. Every financial company in existence will operate under the threat of immediate seizure. If you think the politicians can be relied wield the resolution authority only in high-minded ways, you don’t know much about politics. President Obama spent much of the last year jawboning the banks to make loans for which there was either no demand or no creditworthy borrowers. So the banks wisely resisted; a year later, most are well on the way towards repairing their balance sheets. But how would the banks have reacted, do you suppose, if the President could have backed up his jawboning with the threat of unilateral resolution? That would not have been a good thing. Beyond that, financial crisis or not, what would keep the government from using the implied threat of resolution authority to subtly get banks to steer credit to politically favored borrowers or industries? You think I’m being paranoid. Maybe. But I can’t think of any power the government has that’s as similarly sweeping as the resolution authority being considered in this reform bill. And I’m hard-pressed to doubt that the government will be tempted to abuse it.
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