Weird flaw in the administration's financial reform proposals

Treasury just released the legislative language for its financial reform proposals, so I haven't had time to study them in any depth.



But one thing that jumped out at me as an obvious flaw is that Tier 1 financial holding companies are not automatically subject to the proposed resolution authority for systematically important financial institutions. This is very bizarre.



Tier 1 FHCs are financial companies whose "material financial distress ... could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress." The failure and resolution of a Tier 1 FHC would, by definition, threaten the stability of financial markets. You can't even be a Tier 1 FHC if your failure wouldn't pose systemic risks. So why wouldn't the proposed resolution authority for systematically important institutions automatically apply to Tier 1 FHCs?



For some reason, however, the administration's formal proposal requires an official "systemic risk" determination—which is separate from the determination that a financial company qualifies as a Tier 1 FHC—before the new resolution authority can be used, even for Tier 1 FHCs. An official "systemic risk" determination requires a written recommendation from the Fed and, depending on the nature of the failing financial company, either the FDIC or the SEC. After receiving the written recommendation, the Treasury Secretary, in consultation with the President, can then make an official systemic risk determination.



Why require an official "systemic risk" determination before invoking the new resolution authority for Tier 1 FHCs? It would have already been decided that the failure of a Tier 1 FHC would pose systemic risks, because the definition of a Tier 1 FHC is a financial institution whose failure would pose systemic risks.



Requiring an official "systemic risk" determination will unnecessarily create uncertainty about which resolution regime Tier 1 FHCs will be subject to. Creditors have different rights under the proposed resolution regime than they have in bankruptcy, and the uncertainty about which resolution regime will be applied could easily scare off potential creditors. For something as important as the resolution of a Tier 1 FHC, markets need to know the rules of the game. If the proposed resolution authority automatically applied to Tier 1 FHCs, then as soon as a financial institution is designated a Tier 1 FHC, markets would know which resolution regime to expect if the institution failed, and would be able to adjust accordingly.



Why create the possibility that a financial institution whose failure would pose systemic risks might not be resolved under the resolution authority specifically created for systematically important financial institutions?



This is just setting the markets up for another Lehman-like surprise decision at the worst possible time. Investors were absolutely convinced that the U.S. government would bail out Lehman, because Lehman was much bigger than Bear Stearns, which the government had bailed out, and because surprisingly few investors understood the politics of the situation. Lehman's failure was therefore a risk that most funds had not priced in, and when the government decided to let Lehman fail, the sudden, systemic repricing, coupled with the market's general shock at the government's decision, played a big role in setting off the financial panic that ensued.



Similarly, markets will assume that all Tier 1 FHCs will be resolved under the new resolution authority, rather than bankruptcy. The way the administration's proposal is drafted now, it's possible that a Tier 1 FHC could fail without a "systemic risk" determination being made (forcing the Tier 1 FHC to file for bankruptcy), which would shock the markets, and might cause a mini run on the other Tier 1 FHCs. I've seen that movie before, and it doesn't have a happy ending.