Corporate & Securities Law

By Jim Hamilton

Senator Richard Shelby believes that the financial regulatory reform legislation reported out of the Banking Committee does not go far enough to end the ``too big to fail?? problem and the moral hazard that comes with it and, indeed, institutionalizes the ``too big to fail?? doctrine. In a letter to Treasury Secretary Tim Geithner, the Ranking Member said that the resolution regime erected by the bill does not ensure that taxpayers are protected from the costs of bailing out failed financial firms. For example, the senator pointed out that the bill provides the Federal Reserve with enhanced emergency lending authority that is open to abuse. Because the Fed is authorized to determine if collateral is satisfactory, it could provide widespread bailouts by making emergency loans against bad collateral. Senator Shelby was responding to the Secretary?s recent statement that the draft legislation meets the objectives that the senator laid out in remarks the senator made last year in a speech at the Oxford Union.

In the letter, Senator Shelby also noted that the bill authorizes the FDIC and Treasury to provide broad debt guarantees in times of economic distress when firms face a liquidity event. Because defaulting guarantee recipients are not required to be placed into FDIC receivership, bankruptcy or resolution, this broad authority would give the FDIC and Treasury a backdoor way to prop up failing institutions. In the senator?s view, a resolution regime can be credible only if the government does not have the authority to bail out failing firms.

Further, the bill sets up a $50 billion fund that, while intended for resolving failed firms, is available for any purpose Treasury sees fit. According to the senator, the mere existence of this fund will make it too easy to choose bailout over bankruptcy, which reinforces the expectation that government will intervene on behalf of large financial firms.

The legislation also charges the Fed with special oversight of firms with assets over $50 billion as well as other systemically significant financial firms. In the senator?s view, the market will view these firms as too big to fail and implicitly backed by the federal government. Senator Shelby viewed this as akin to setting up dozens of new government sponsored enterprises that will inevitably receive funding advantages.

In his remarks to the American Enterprise Institute, Secretary Geithner quoted Senator Shelby?s earlier remarks calling for a resolution regime for large failing financial institutions that provides clarity to creditors and to the market and operates similarly to bankruptcy proceedings, with clearly delineated procedures for settling claims. The Ranking Member said that a well crafted resolution regime may require rapid access to liquidity to provide confidence to counterparties, thus reducing the need to redeem short-term claims in the face of dwindling assets. As with deposit insurance, assurances must come at a cost to those needing the resources, not at a cost to taxpayers.

The financial reform package passed by the House last year would create a resolution authority to wind down large, interconnected, financial companies in an orderly manner. The legislation thus seeks to end ?too big to fail? by empowering federal regulators to rein in and dismantle financial firms that are so large, interconnected, or risky that their collapse would destabilize the entire U.S. financial system. Legislative history indicates that there is nothing in the legislation that allows a failing institution to be continued with federal money. HR 4173 creates a dissolution fund, not a bailout fund.

Full post as published by Jim Hamilton's World of Securities Regulation on March 26, 2010 (boomark / email).