A Market Test for the FDIC's Resolution Authority

There's a lot of debate about whether the FDIC's proposed resolution authority — where it would have the same wind down powers over mega financial institutions as it does for common banks — will work as promised.

In a paper released by the FDIC, the regulators argued that the senior unsecured creditors of Lehman Brothers would have recovered 97 percent of their claims had it been able to exercise resolution authority in 2008. That's far better than the expected 21.4 percent recovery they are likely to see through the bankruptcy process.

Is this claim credible? We'll soon have a market test.

If the market believes resolution authority will work as promised, there should be a dramatic decline in the price of credit protection for financial companies subject to resolution.

"When we come to pricing a senior unsecured CDS, we assume a 40% recovery rate. At this rate, investors using a CDS hedge are insuring 60% of the notional bond value. If the recovery rate assumption is shifted up to 80%, the notional insured value is reduced to 20%, a third of its original value. So if a financial name is trading at 100 basis points under a 40% assumed recovery rate, it will trade at around 33bp under an 80% assumed recovery rate," one senior credit trader at a large investment bank tells Risk.Net.

One problem, however, is that this could lead to lax risk management.

If the cost of credit protection for our biggest entities declines not because they are less risky but because a government program will reduce the costs to creditor of failure, we'll get less outside risk supervision. The bond market vigilantes will be able to nap.

Are we really sure this is good for safety and soundness?

If credit default swaps don't decline once resolution authority is in place, this will amount to a tacit rejection—or at least skepticism—about the effectiveness of resolution authority. So watch the numbers closely.

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