Saturday, January 1, 2011

Dodd-Frank: The Good Stuff

. Saturday, January 1, 2011

Economics of Contempt has a wonderful two-post series on the importance of resolution authority for bank regulators. Basically, this means that when a large bank goes under, there needs to be a process in place for dealing with the bank's creditors. Why is this important? He lays it out in part one:

To take one example: Lehman’s holding company (LBHI) filed for bankruptcy, but at the last minute its US broker-dealer (LBI) was kept out of bankruptcy by the NY Fed. The problem was that no one knew about this — most people thought LBI had filed too. Lehman had all sorts of problems getting employees to even show up for work; JPMorgan, which was LBI’s clearing bank, unilaterally shut off LBI’s access to its accounts for several days, and actually started seizing assets of LBI’s prime brokerage clients (a huge no-no); clearinghouses improperly limited LBI’s trading activity; the NSCC mistakenly seized a large amount of LBI’s customer securities; Lehman’s European broker-dealer (LBIE) stopped payments to LBI’s omnibus account even though LBI continued to make payments to LBIE; incoming customer securities to LBI weren’t getting properly segregated; counterparties simply stopped posting collateral they owed on OTC derivatives with LBI; and so on. That first week, the biggest challenge was simply getting someone at Lehman on the phone. (I saw a 63-year-old senior partner do a fist-pump you’d have to see to believe when he finally got an account executive at Lehman on the phone. Unquestionably the highlight of my week.)

You get the picture: it was utter chaos, in no small part due to sheer confusion about what was going on.


He argues that a big reason why Lehman's collapse had such a huge effect on financial markets is that nobody knew what was going on, how much of their money was lost, or even who to call to try to get it back. Given the similar concerns about basically every other Wall Street firm, investors had no idea if their funds were safe, or if/when they'd be repaid if their counterparties went under.

This gets even more complicated when you consider international firms. Which country's creditors get paid, and which get left in the cold? This is part of the ongoing Basel negotiations:

Lehman’s collapse also showed the need for a cross-border mechanism to wind down failing banks that have a global reach. More than 80 proceedings against the firm, involving hundreds of subsidiaries worldwide, have complicated recovery by creditors and destroyed much of the value of its assets.

The Financial Stability Board, which includes most Basel committee members as well as finance ministers from the Group of 20 nations, struggled to come up with such a resolution mechanism this year. The FSB postponed a decision until next year after divisions among nations proved too wide to bridge, members said. The group has been unable to agree on how to distribute losses among countries when a global bank fails and how different legal jurisdictions can recognize a single authority to pay creditors, the members said.


Fortunately, the Dodd-Frank bill gives the U.S. government resolution authority, and there is a similar mechanism in place in the U.K. As Econ of Contempt notes in part two, those are the only two countries that really matter:

What about all those thorny international problems? Well, the truth is that in terms of systemic risk, there’s only one other jurisdiction that really matters: the UK. New York and London are still the two dominant financial centers, and the vast majority of transactions at the major US banks flow through either New York or London. It’s important to understand that it was the UK’s ridiculously backward somewhat dated insolvency regime that forced the liquidators of Lehman’s European broker-dealer to seize so many client assets and assets of affilates. Fortunately, the UK now has their own version of the OLA, which they call the “Special Resolution Regime,” and was enacted as part of the Banking Act of 2009. The Special Resolution Regime is, like the OLA, modeled explicitly on the FDIC resolution authority, and gives the Bank of England the same wide-ranging tools to wind down a London broker-dealer in an orderly fashion — including, significantly, the power to create “bridge banks” to ensure that key functions can continue uninterrupted. Cross-border problems that aren’t identified and dealt with in the resolution plan can, if necessary, be dealt with by bridging the relevant entities until a solution can be fashioned.


I like this line of argument, and I've made the case several times before that basic ignorance was a major problem in the crisis. In my first post on Dodd-Frank I argued that the provisions that increased transparency in the financial system, like resolution authority, were much better than trying to create the perfect regulatory structure that would prevent financial crises from occurring in the first place. The latter approach is sure to fail. The former can do some real good.

I strongly recommend reading both of these posts. They are wonky, but if you are interested at all in what Dodd-Frank did, or why it's important, you'll learn quite a lot.

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Dodd-Frank: The Good Stuff
 

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