Every now and then an idea takes hold that is, conceptually, so elegant and alluring as to be nearly irresistible. Resolution authority – like the call of the Sirens – has enchanted every US official who was in a decision-making capacity during the financial crisis.
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It’s not hard to see why.
Read the tick-tock accounts of the excruciating decisions then-Treasury Secretary Hank Paulson, Fed Chairman Ben Bernanke, and then-New York Fed President Tim Geithner were confronted with to try to prevent the collapse of large, complex, financial institutions during the fall of 2008. You see why they would want a clean, predictable process.
Instead, what occurred was messy, ugly, and unpredictable. It required them to act – simultaneously — as matchmakers, firemen and undertakers, and with imperfect or non-existent tools for the job.
The result with Lehman Brothers was a spectacular failure that further rocked a global financial system already reeling in crisis.
So, resolution authority – the power and means to deal with just such a failing firm as Lehman Brothers – promises to prevent the chaos and confusion of September of 2008.
Most of the criticism of resolution authority has focused on its characterization as a ‘bailout fund’, or on the ‘moral hazard’ aspects – that firms will enjoy a cost-of-capital advantage, or that they will be more likely to take exceptional risks knowing that damage will be mitigated and counterparties will be paid off.
There’s another more practical concern: When do you use the authority, and what are the consequences of having the authority in the moment?
Make yourself Treasury Secretary or Fed Chairman, and take a look at the chart below of Lehman Brothers’ death throes in 2008:
Forget that the entire financial system was in crisis, and that lots of other banks had charts similar to this in the 2nd half of 2008, and assume Lehman is the only is the only faltering institution. Consider these questions:
1) What are your goals as you see Lehman’s slide?
2) What are you doing in the period leading up to your decision to take Lehman into bankruptcy?
3) What are the likely actions by market participants, counterparties, and potential investors in Lehman doing while you decide?
4) At what point do you, as Treasury Secretary, make the determination to step in and take Lehman Brothers into bankruptcy?
And finally, Will the availability of resolution authority make it more or less likely that you can achieve your goals?
These are the most important, practical questions in trying to anticipate if resolution authority – however comforting in concept — is a good or bad tool for policymakers.
If you are Treasury Secretary in the months leading up to Lehman’s collapse, you’re goal is to avoid using your resolution authority. Your primary objective is to find some way to encourage the private sector to step up. So you’re doing exactly what Hank Paulson was doing in the summer of 2008 – encouraging Lehman CEO Dick Fuld to either raise capital or find a buyer.
Market participants and potential investors are watching you, looking for signals for your likely answer to question #4. Knowing that you have resolution authority and can come in at any moment to take down the firm, they’re wondering why in their right minds would they ever put a dollar into this failing institution today if the Treasury Secretary can come in tomorrow and wipe them out. (To prevent flight in the case of Fannie Mae and Freddie Mac, recall Secretary Paulson insisting on reassuring investors that the firms would continue “in their current form as shareholder-owned companies”, as he sought authority to deal with the GSEs. It didn’t work.) In fact, the very availability of resolution authority, and the unpredictability of when and under what conditions government would use it -- wiping out equity investors and removing management -- is more likely to speed up investor flight, not encourage them to step in to help. In other words, an outcome precisely opposite of your goal as Treasury Secretary.
Lehman Brothers, it should be noted, may have been salvageable. At the time a Treasury Secretary with resolution authority might be seeking to shutter the firm, the bank’s officials were actively courting large investors and seeking a buyer. They actually found one in Barclays, although it was scuttled by UK authorities. There were lots of reasons why other firms walked away from Lehman – not least were their own precarious positions — but it’s hard to imagine resolution authority making them more likely to step in under similar circumstances.
Looking at the Lehman chart, I suspect the end for Lehman would have come much sooner had resolution authority been available, and the potential to save it with private sector financing greatly diminished.
I understand the allure of resolution authority, but we should be careful what we wish for, and a lot more realistic about its impact.
An easy process to deal with a failing institution is likely to be counterproductive, and at the end of the day, government involvement with a private firm should be extraordinary and extraordinarily difficult.
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Tony Fratto, a CNBC contributor, is Managing Director of Hamilton Place Strategies – a strategic economic policy and communications firm based in Washington, DC. He is a former White House Deputy Press Secretary for the George W. Bush Administration and Assistant Secretary of the Treasury. You can follow him on Twitter at .