Serving the FDIC's Interest

In a recent speech, FDIC chair, Sheila Bair laid our her vision for financial services regulatory reform.

She starts from the common-sense premise that "we need an end to the too big to fail doctrine". She proposes a "mechanism for the orderly resolution of these institutions similar to that used for FDIC-insured banks." She argues for extending this mechanism beyond the large bank holding companies to smaller bank holding companies, hedge funds and insurance companies. She expressed support for the international initiative towards the development of wind down plans providing they "be developed in cooperation with the resolution authority". Finally, she also proposes considering "limiting the claims of secured creditors to encourage them to monitor the riskiness of the financial firm." She believes that short term secured borrowing "may encourage greater fragility in the financial markets" and that taking money from secured creditors and giving it to general creditors would serve "to stem any systemic risks."

The most striking feature of her analysis is that, to her, the "too big to fail doctrine" is false. That with a structured resolution process no firm is too big to fail. As noted previously, an FDIC-style resolution process works well when disposing a relatively tiny amount of assets into a large market. It can not be reasonably expected to work as well disposing a more meaningful proportion of assets in market.

That large and/or interconnected companies should maintain "living wills" is an almost inescapable take-away from the Lehman bankruptcy. Mandating that any such company (including non-financials) maintain active shareholder and creditor approved pre-packaged bankrupcy plans appears a no-brainer. Bair, rightfully, notes that such plans can improve systematic resilience by highlighting risks and dependencies. More questionable is her insistence on regulatory agency participation in, or rather -- let's not kid ourselves -- control of, developing these plans. Without regulator intervention, this sort of rule would create structural pressure against firms too big or complex to fail. The bigger and more complex a firm is, the more difficult it will be for shareholders and creditors, by themselves, to reach agreement.

Demanding that smaller firms that could be otherwise be reasonably wound down through existing mechanisms maintain "living wills", as Bair appears to support, is the sort of regulation-as-barrier-to-entry that larger firms love.

At first glance, her argument to mandate haircuts for secured creditors is unequivocally idiotic. If shareholders, regulators and unsecured creditors cannot together adequately monitor the riskiness of a firm, how could secured creditors? How does taking money from secured creditors and giving it to unsecured creditors stem any systemic risk?

Most risible is the suggestion that secured lending "encourages more risky behavior." Bair surely knows this is false: Systemic risk is primarily caused by unsecured rather than secured lending; A firm's secured borrowing cannot get out of hand, as a firm has finite assets to borrow against. If one only lends securely, one is not put at risk by a borrower defaulting. In truth, unsecured borrowing is also, generally, a check on excessively risky behavior as lenders demand higher rates from firms perceived as more risky. The financial system did not work this way because the government subsidized unsecured lending: In the first instance via the implicit "too-big-to-fail" guarantee, but also via the FDIC itself -- a bank account is nothing more then a unsecured loan to the bank.

Her true motivation appears clearer when one considers that the FDIC is running out of money. It would sure benefit from being able to seize 20% from secured creditors of banks it takes over. Similarly, to argue for an FDIC-like resolution process to be expansively applied is, between the lines, to argue for a dramatic expansion of FDIC authority. It should be no surprise that Bair argues as forcefully for regulation in her agency's interest as she opposed regulation against her agencies interest. It is unfortunate that the regulator cannot be relied on to, instead, defend the public interest.