Momentum appears to be gathering to establish a systemic risk authority and grant to it the powers similar to those available to banking regulators to resolve troubled institutions that may pose systemic risks to the financial system and to the economy.  Chairman Bernanke and Secretary Geithner, as well as other banking regulators, have asserted that the lack of such authority was a major reason that the government was faced with the either/or option of either a disruptive bankruptcy or a government bailout in resolving Bear Stearns, Lehman Brothers, and AIG.  This stands in sharp contrast to how the FDIC insured financial institutions Countrywide and Wachovia were resolved.  The negligible market reaction and lack of negative externalities associated with how these latter resolutions were handled were striking when compared to the fallout from the Bear-Lehman-AIG scenario.   Reliance upon the general bankruptcy statutes, as we do for non-banking firms (and as Europe and most other countries do for both banks and non-bank firms) involves uncertainty for creditors and lengthy delays to access funds and services before business can be resumed.  This uncertainty and its costs create incentives to deny funding and pull business from troubled firms and can generate significant market disruptions. 

There are, however, two critical issues that must be confronted as Congress contemplates granting new resolution powers and systemic risk responsibility to the Treasury, Federal Reserve or to some other authority.  The first is the need to clearly specify the criteria to be used to identify those institutions ex ante as to which bank-type failure resolution procedures should apply.  This will truncate uncertainty about the status of debt claims and the ability to conduct normal business so that creditors and customers know in advance the risks and potential delays they may be subject to in the event the firm they are doing business with or are funding should get into financial difficulties.  The criteria should specify how and when to exclude institutions from coverage whose size or activities no longer warrant treatment under special bankruptcy procedures. Without such a set of rules, the authority will simply be a wildcat agency whose actions or lack of actions will only enhance market uncertainty.

The second issue is to recognize that there are practical limits, especially in the case of large financial conglomerates, to the ability of the US government to grant any regulatory body the authority to close or resolve an institution with multiple subsidiaries and affiliates chartered in many different legal jurisdictions and countries.  NY Fed President Dudley summarized the problem well in his recent testimony before the House Financial Services Committee when he described the difficulties Lehman Brothers and AIG presented to the government:

In the case of Lehman, some of the most severe repercussions related to the difficulties in coordinating cross-border insolvency regimes and in coordinating the insolvency regimes among different types of institutions within the organization’s corporate structure.  In light of AIG’s unparalleled global footprint – operating in more than 130 countries around the globe – and the multiplicity of different types of financial services entities within its structure – including insurance providers, foreign banks, consumer lending companies and OTC derivatives affiliates – the factors that proved unmanageable in the Lehman insolvency threatened to be much more severe in AIG’s case. The fact that no effective emergency resolution procedures exist under U.S. law to reconcile these difficulties heightened the need for quick, effective action by the Federal Reserve, in consultation with and supported by the U.S. Treasury.

In addition to President Dudley's points, however, is the fact that the US government has no legal authority to grant any regulator the power to close affiliates and subsidiaries of US conglomerates chartered by other sovereign states nor to ring fence or to claim jurisdiction over assets owned by those foreign chartered entities.  These are not new problems and have surfaced before in the BCCI failure, but have yet to be addressed satisfactorily. 

It is simplistic to suggest that lack of legal authority was the prime barrier to resolution of Bear Sterns, Lehman Brothers and AIG.  It clearly was a factor, but the same problems would exist for the FDIC to deal with JPMorgan Chase or any other large banking organization.  Wachovia, Wamu and Countrywide were relatively simply cases because the bulk of their assets were in US chartered banks, subsidiaries and affiliates.  This simply wasn’t the case with Lehman Brothers or AIG.  It is also not likely to be the case for other institutions that might possibly be designated as systemically important institutions and subject to the new regime.  In fact, such institutions are even more likely to conduct business through foreign-chartered subsidiaries and affiliates in order to protect certain assets from the new resolution procedures. 

Fair questions to ask Secretary Geithner and Chairman Bernanke, who are urging the granting of new resolution powers are:

1. Exactly what powers would you have needed to deal with AIG differently and what would you have done? 
2. How would you have dealt with the foreign subsidiaries and what proportion of AIG’s resources would have been out of reach and/or potentially at risk because of inter-company dealings through its securities lending and derivatives activities?
3. Would the procedure have enabled the separation of AIGFP from the rest of the company at that time?  What would have happened if the entire AIGFP operation had been headquartered in the UK instead of only part of its operations?

We could learn a lot through a careful forensic investigation of the AIG, Bear Stearns and Lehman Brothers cases, which might aid in structuring any changes in regulations and resolution authority.  Those investigations should proceed before there is a rush to re-regulate. 

In the last day, Secretary Geithner has now proposed that resolution powers be shared between Treasury and the FDIC specifically, and perhaps with the Fed in some way as well.  This is merely shifting of responsibilities but does not address the specific powers, authorities and funding that would be needed to make such an authority an effective contributor to financial stability.  In addition, discussion also seems to be coalescing around the idea that the systemic risk authority might even have prior approval and/or the ability to determine the suitability of certain financial instruments and financial innovative products for customers like the Food and Drug Administration has for medicines.  Should that responsibility be given to the systemic risk authority or any other governmental body, then the US financial system will surely fall to the bottom of the heap relative to financial markets in the rest of the world.