A government resolution about regulatory reform?

Claw backs, cram downs, and resolution authority

Once one accepts that no organization is really too big to fail, one is faced with the issue of how to let them fail (i.e., resolution authority). But, that ultimately leads into the consequences for different players. Thus, cram downs and claw backs have to be addressed. Viewed through this lens, the idea of too big to fail (TBTF) can be seen as a really bad solution. TBTF assumes that throwing more money at the problem is an acceptable substitute for addressing negative consequences. But, wasting capital has its own severe negative consequences; never mind the moral hazard issue. While it is important and inflames the public, it is minor compared to other consequences.

It is easy to ignore these issues. They’re complicated, but ultimately they’re crucial. But the form cram downs and claw backs take are less important than that something gets done. It would be dangerous to let the complexity of cram down and claw back-related issues delay addressing the need for wind down options.

To illustrate the importance of a wind down option, consider this scenario: assume there is a run, a sudden demand for liquidity; each little run sets off another run; eventually the cascade gets noticed. The government decides to throw money at the problem, thereby avoiding the pain of wind downs. Their solution is to keep every big player going. Where has the run risk gone? Well, seems that only two possibilities exist: either the run risk went away, or it shifted to the government.

Under what conditions could it go away? If it is truly just a liquidity problem, it will go away. The government has adequate liquidity, and since it is just a liquidity problem, there are assets that can serve as collateral for the liquidity injection. It could also go away if any other player or set of players has the liquidity, although that could touch off the jealously of other players.

This solution to liquidity problems can not work if a wind down is not a viable alternative. The insolvent institutions have every incentive to accept the loan. Illiquid firms have every incentive to accept the loan as their first response rather than looking for alternatives, and organizations with liquidity will hold onto it since they will be undercut in the market. They, after all, have to worry about counterparty solvency. Consequently, it becomes impossible to differentiate between illiquid and insolvent organizations. Further, since there is a confounding of liquidity and solvency issues, it is impossible to tell when the liquidity crisis has passed.

If the run really represents balance sheet problems beyond liquidity, throwing money at it only delays and grows the problem. No one, not an individual, not a business, not a government, not even a society, can consume more than its income indefinitely. It should show up as negative cash flow, and, under an honest accounting, as assets that are lower in value than the liabilities. Without a wind down option, the government is stuck with the negative cash flow. It has just transferred the problem, not eliminated it. Further, without a wind down option, there is no exit strategy other than to hold on and hope the problem goes away.

The absence of a wind down option creates the potential of an even greater risk. The risk can also go away when it was just a crisis of confidence if there is an engineered restoration of confidence. It can be engineered by convincing the market participants that counterparties are TBTF. But, relying on the TBTF approach just shifts the risks. Throw enough money at it and the government owns the problem. The risk is now a risk to the government. Note that, in this case, the absence of a wind down option results in a risk of failure regardless of whether the original problem was liquidity or solvency. Not sorting out who is and isn’t solvent calls into question the solvency of anyone who owns the problem.

Recently commentators have realized the current problem is a balance sheet-induced recession. Similarly, Bill Gross at PIMCO has referred to corporate and sovereign debt as being comparable, more competitive. Even politicians have found it very stylish to discuss the national debt. Sovereign risk is finally getting some press. That begs the question: is the balance sheet problem one of liquidity or something more serious?

By avoiding winding down insolvent organizations, the government ends up having to prove that it is TBTF. Here the consequences can be truly ugly. Possibilities include sovereign default. Sovereign default can take multiple forms such as literal default, inflation, or by just not honoring commitments like loan guarantees and pensions (SS and Medicare cuts anyone?). A government can try to quiet default concerns by constraining
macro policies. For example, the government might be pressured to tighten monetary policy or eliminate stimulus too early and thereby risk a double dip (i.e., another recession). Another risk is currency collapse and/or the loss of international confidence with associated interest rate spikes in debtor countries like the US.

All-in-all, we seem to have been so motivated to avoid wind downs that we responded by carelessly throwing enough money at any problem. We eliminated a liquidity problem and avoided facing solvency issues. However, all we did was transferred a lot of risk to the government. We didn’t address some solvency issues and we transformed liquidity issues into questions about solvency.

Market interventions to halt a cascade don’t have to take any specific form. Sometimes loans are appropriate, sometimes wind downs, and sometimes direct intervention. And, yes, if solvency isn’t the issue, just convincing the market that the next organization is TBTF is the solution. But, without a wind down option, the default is TBTF without any guarantee of solvency. In short, if we don’t address how to let big firms fail, we risk an even bigger failure.