Risk and Discipline in the Financial Markets: New resolution authority can help convince banks they're not too big to fail

Risk and Discipline in the Financial Markets. By ARTHUR LEVITT
New resolution authority can help convince banks they're not too big to fail.WSJ, Feb 22, 2010

There is now a high probability that the greatest financial crisis in three generations will yield not one piece of meaningful financial regulatory reform. Perhaps the last best chance to rescue the situation rests with Sens. Christopher Dodd (D., Conn.) and Robert Corker (R., Tenn.), who are at work on a compromise bill.

Their goal should not be just any bill, but one that addresses the corrosive effects of a system in which massive institutional failure and total loss are impossible. The policy bias against letting failure occur was regrettable but excusable in the fall of 2008. Now there is no reason for it.

Too many regulators, politicians, bankers, credit rating agencies and others have believed failure was not an option. In financial markets, when people take risks and don't anticipate failure, they take greater risks and the resulting failure becomes far more damaging.

There is still time for the White House and Congress to re-institute the principle of failure in our financial marketplace. It may not be as sexy as the creation of a consumer protection agency or a reorganization of the federal regulatory landscape. But it is essential.

It can be done in two ways. First we should address the problem of "too big to fail," in which large financial institutions are not allowed to fail because of the impact their failure would have on the rest of the market. Second is the problem of "too interconnected to fail," which is a variation on the same theme: when a financial institution's positions in the unregulated and non-transparent derivatives markets are so complex, so secretive, and so leveraged that to unwind them quickly is either impossible or dangerous.

The problem of "too big to fail" is behind President Obama's support of the so-called Volcker rule, which would prevent banks from getting too big by limiting their ability to engage in proprietary trading or run their own hedge funds or private equity funds. But this would not end the de facto government backing of big banks. Indeed, it is premised on the idea that because these banks will be protected from failure, they should not be permitted to engage in these activities. Far from ending the problem of "too big to fail," the Volcker rule practically institutionalizes it.

The only reasonable solution to "too big to fail" is the creation of a resolution authority that makes the failure of any financial institution possible and orderly—something I am glad to say Paul Volcker has supported as well. The rights and responsibilities of equity holders, bond holders, other creditors and management would be spelled out—in advance. If a bank or financial institution should require the direction of a resolution authority, failure might not be the only option, but it would remain the first one. That prospect alone would reintroduce the risk of failure in our financial markets.

The problem of "too interconnected to fail" is just as critical. The unregulated and fast-growing market for derivative products helped cause the financial crisis.

There were—and are—several features to this market that make it a petri dish for systemic risk. There is no transparency around volumes, pricing and outstanding positions. These derivatives often do not go through central clearing houses, which validate and guarantee counterparty trades. Traders often rely on collateral positions and favorable but disruptive unwinding practices to protect themselves from the significant risks associated with derivative instruments.

Even now, there is no reason for traders to be more focused on credit discipline because these derivatives enjoy a special bankruptcy court protection normally extended only to certain government securities and foreign exchange transactions. Such protections were put in place so that government repos, which are vital to the funding of government operations, are not frozen by bankruptcy court actions. But the cost of these protections when extended to OTC derivatives is paid for by other creditors—as Lehman's creditors are now discovering.

All of these features make derivatives a source of "too interconnected to fail" and invite regulatory action. Several steps should follow:

First, we must officially end the unregulated status of these markets going forward—something that has been proposed before, but to no avail.

Second, rather than determining in advance which new derivatives need to be cleared, we should create incentives for that process by setting higher capital requirements on noncleared contracts. Not all derivatives will go to clearing houses—but a great majority of them will.

Third, to meet the greater volume, we need to invest in the institutional capacity of the clearing houses.

And finally, Congress should set a date certain—two years from now—at which point the special bankruptcy status of noncentrally cleared derivatives will be eliminated. This rule would only apply to new contracts.

These steps would re-introduce real credit discipline, while improving market transparency at all levels—all without forcing federal regulators to struggle to develop a rule that would somehow define a standard contract in a marketplace where variety and diversity is the norm.

Some will say that regulating OTC derivatives and creating a strong resolution authority would make the U.S. a "less competitive" financial marketplace. I doubt it. Investors will go to the financial marketplaces that offer the best protections against systemic risk. That has always been true and is especially true today.

Mr. Levitt was chairman of the Securities and Exchange Commission from 1993-2001 and is currently an adviser to Goldman Sachs.