AFR to Senators: Create a Sound and Functional Resolution Authority

February 1, 2010

The Honorable Christopher J. Dodd

The Honorable Richard C.  Shelby

The Honorable Robert P. Corker

The Honorable Mark R. Warner

Mr. Michael S. Barr

Dear Chairman Dodd,

We, the organizations comprising Americans for Financial Reform (AFR), are writing to convey our views on the creation of a sound and functional resolution authority. We commend Senators Warner and Corker for their many months of hard work on this very complex and important set of issues. However, we have serious concerns with the model, as we understand it, which is emerging from their deliberations. These concerns go to the very heart of the national debate over financial reform-will we do the best we can to prevent future bailouts by the American taxpayer? Like Senators Warner and Corker, we seek reforms that will prevent another such crisis and bailout. However, we fear that a preference for bankruptcy over resolution fails to prevent the stark choice the nation faced a year ago from reoccurring.

Prudent policy should prefer resolution for non-bank financial institutions as a means of preventing systemic risk to the broader economy. While proponents of the Corker/Warner model may claim that a bankruptcy-first option will deter bailouts, most observers recognize that the lack of swift administrative resolution authority for failing financial firms was what forced the government to issue bailouts last year. To prevent future ad hoc bailouts, resolution authority must wipe out shareholders, replace management, and impair creditors.

Bankruptcy is not a resolution. There is a reason why, in the wake of Lehman, bankruptcy was not a viable option last year, even though it was available under existing law. Court proceedings move slowly, as opposed to quick-moving administrative proceedings, such as a resolution. The ability to respond quickly to a brewing crisis is of paramount importance. Erecting procedural delays, such as a hearing to consider the advisability of bankruptcy before resolution, could force bailouts during a crisis, an outcome everyone would like to avoid.

Bankruptcy is not a free-market solution, especially when the process is adjudicated and the financing is provided by the government.

Despite the rhetoric, resolution authority is NOT a bailout. It has not been a bailout for the over 140 banks that the FDIC has resolved in the past year. It is the means by which a failed firm is terminated. Bankruptcy is a second chance. Resolution does not create moral hazard; it is punitive. Equity holders are wiped out, non-deposit creditors take haircuts, and management and the board of directors are removed. In addition, resolution authority allows intervention before a crisis takes hold. Bankruptcy requires a default before efforts can be made to save a failing firm, increasing the likelihood of a bailout.

Logically, the decision to place a firm in resolution or bankruptcy should be made by the firm’s prudential regulator or the market stability regulator who will understand the complexities and systemic considerations immediately. A bankruptcy judge, liable to ignore third-party ramifications, is not qualified to make a decision of such systemic importance.

Any resolution should be funded from an ex ante assessment and, if necessary, a pre-arranged line of credit from the Treasury, with the FDIC acting as the operational resolution authority. Where ex ante assessments efficiently distribute the cost of systemic risk to the risk-takers, post hoc assessments run a great risk of being pro-cyclical and lead to a temptation to resort to bailouts.

Traditional bankruptcy includes so many disadvantages within this framework that we are seriously concerned with the model as we understand it. Resolution is the clear choice if the goal is to avoid future bailouts, while ensure the safety of our financial system.

Because an overall agreement might be reached in short order, we thought it best to convey to you our thoughts regarding the foregoing and see if a meeting to discuss it may be possible.

Yours Truly,

Americans for Financial Reform

CC: Mr. Steven Verdier, ICBA

Ms. Renee Rappaport, ICBA

Professor Jane D’Arista, SAFER

Professor Gerald Epstein, SAFER

Professor Jennifer Taub, SAFER