Yves Smith quotes Robert Johnson explaining why a resolution authority will fail when “too big to fail” financial institutions are wrapped in a web of complex derivatives. He calls these unresolvable institutions “too difficult to resolve”:
Yet opaque, complex entangled derivatives exposures would serve to deter the authorities from invoking those powers [granted by the resolution authority] and taking over a failing institution for fear of setting off a system wide calamity of magnitudes that policy officials can dread but not understand or estimate. Complex entanglements through derivatives exposures discourage government officials who are the risk managers on behalf of the citizens of our nation from invoking and using those powers. The spider web of complex opaque derivatives renders enhanced resolution powers impotent.
It is in this respect that complex and opaque derivatives exposures at large financial institutions contributed mightily to a policy of induced forbearance, as we witnessed in the first quarter of 2009. That experience, as we have seen, was very demoralizing to our citizens who have put their faith in philosophies that emphasize the use of markets as a mechanism for achieving social goals. The inhibitions that authorities experience in applying market discipline to large financial institutions and their managements tend to undermine belief in the use of markets.
What makes induced forbearance of TDTR institutions even more troubling is that their potential creditors would understand that they will not have their debts restructured when government officials are deterred by complex derivative exposures from taking a TDTR institution into receivership and restructuring the entity. …
While there is no question that derivatives make the resolution process more difficult, standard procedure (that is, the rules for FDIC receivership) gives regulators a powerful tool: They have the right to move the failed institution’s derivative portfolio — or a portion of the derivatives portfolio as long as each portfolio that relates to a specific counterparty is kept intact — to another institution or bridge bank.
I commented on this issue over at Naked Capitalism and I think I overstated the degree to which Yves is correct that derivatives make resolution very difficult. Yves explained her view that the transfer of the portfolio will not work in a comment:
You can’t just “move them [the derivatives] over.” They trade in relationship to cash markets, and most are hedged dynamically, meaning positions are adjusted several times a day. And the derivatives are used to manage risks in the cash books. Banks and financial firms would have to sell a simply enormous amount of cash positions if they could not lay off risks via derivatives.
This would be like trying to remove someone’s colon using a hacksaw with no anesthesia.
You’d need a bigger balance sheet than that of all the banks (ie, this becomes the biggest commitment of the central bank). You also need people to manage the positions, the trading tools, and the computer infrastructure to manage and monitor positions.
As long as regulators prepare carefully, they can deal with all three of these issues. First, clearly they need to build the structure for the bridge bank which will handle the derivatives well before they have a bank to resolve. This is a challenge, but hardly insurmountable. Secondly, they will need to develop criteria for determining what derivatives the bridge bank will sell to the resolved bank to replace the derivative hedges that have been stripped by the portfolio transfer. Thirdly, the resolution authority will need to provide temporary liquidity — possibly in the form of a DIP loan — to give the regulators and the resolved bank time to work through all the issues that are sure to arise in such a procedure.
Would the process be complicated and awkward? Absolutely. But that’s not the question we need to answer. The real issue is: Would it be better than simply handing out money to insolvent private institutions? Rob Johnson is concerned that our regulators won’t use the resolution process, even when it’s available to them. I, on the other hand, think that once the authority has been passed, public opinion will force regulators to use the resolution authority.
Think of how much better AIG could have been handled with a resolution authority in place. Counterparties who did not buy poorly capitalized CDO protection from AIG could have had their contracts transferred into a bridge bank. Then when AIG defaulted on its derivative liabilities only those who faced dramatic losses would have had the right to terminate their contracts. For domestic institutions, any bank that was insolvent after the AIG losses would be put through resolution itself. Foreign institutions would be a political matter and might well be addressed by government to government transfers.
Alternatively in an environment where it was clear that all the major derivative dealers were insolvent (which was arguably the case in Fall 2008), a single bridge bank could be used to resolve all the dealers simultaneously, creating a central counterparty for derivative contracts in one fell swoop and flattening out a lot of the complexity in the market. Once again the problem of liabilities to foreign institutions would have to be dealt with via political channels.
Despite the fact that I think that a resolution authority is a good idea and is essential to help address current financial problems, Rob Johnson makes an important point in calling for “a drastic simplification of derivative exposures”. I think everyone can agree that the best option would be a financial system where a resolution authority is not needed.
The best way to create a financial system which would not use a resolution authority even after it was enacted is to follow the recommendations made in this series of posts:
(i) Prohibit large financial entities from posting collateral on over the counter derivatives. Eliminating the reliance on collateral in interbank transactions will force financial institutions to evaluate the credit risk of their counterparties. Healthy concern for credit risk would do wonders to reduce “interconnectedness” in financial markets.
(ii) Repeal the repo related amendments to the bankruptcy code that were passed in 2005. Eliminating illiquid assets from the repo trade is the best way to put an end to the type of interbank bank run that took down Bear Stearns and Lehman Brothers.