A Proposal for the Resolution of Systemically Important Assets and ...

then it gets treated as being sold and repurchased each day, so that as far as its capital
requirementconcerned,itissubjecttomarketriskforonlyoneday.
Thistransformationofalongtermassetintoanovernightassetisprimarilybecauseof
the repo financier’s right to take over the asset in case of failure of the repo counterparty.
However, as explained above, in many cases repo financiers themselves cannot own these
assets in the long run and must liquidate them upon failure of their repo counterparty.
Therefore, the migration of the MBS from the banking to trading book lowers the capital
requirementagainstitthroughoutthefinancialsystem,sincenoinstitutionisholdingcapitalfor
a scenario where there is systemic illiquidity under which some institution — most likely an
institutionwhichincurredahugeilliquiditydiscountinthefiresaleoftheasset—musthold
theassetforthelongrun.
Suchdistortionspushcounterpartiestowarddesigningcomplexproductsthatcanhelp
shift assets from the banking to the trading book, which are then financed using shortterm
reposintherepomarket,awayfromthemonitoringofregulatorsandatsubstantiallylower
capitalrequirements.Theeffectiveoutcomeistremendousliquidityinrepomarketsforthese
productsingoodtimes,withsystemicstressandfragilitywhentheproductsareanticipatedto
experiencelosses.Theexpansionofsafeharbortorepotransactionswithunderlyingmortgage
basedassetsintheBankruptcyActof2005hasthusbeencitedasoneofthereasonsforthe
growthinmortgagebasedderivativesovertheperiodfrom2005to2007.
TheDFAessentiallytreatsQFCsthesamewaytheFDICtreatstheminreceivershipsnot
coveredbytheAct.Thatis,attheendofthefirstbusinessdayafterareceivershipcommences,
counterpartieswouldbeabletoexercisetheirrightsagainsttheCFCsuchastoterminate,net
out,setoffandapplycollateralwithrespecttoalltheirQFCs.Therefore,althoughtheprovision
ofasafeharborundertheDFAisnotidenticaltothatofthebankruptcycode,QFCsstillbenefit
from special protection. An exception is that until the end of the first business day after
commencement,theFDICwouldbeallowedtotransferall(andonlyall)oftheQFCsbetween
the CFCand a given counterparty. Although such exceptions to the safe harbor clause make
some sense to the extent the systemic risk of financial institutions might vary from one
situation to the next, a better approach would be (Acharya, Adler and Richardson, 2011) as
follows:
1) QFCsthatareliquidshouldkeeptheexemption.LiquidQFCswillcauselesssystemic
risk in fire sales, yet still allow counterparties to manage their risk without the
uncertainty generated by the bankruptcy of a SIFI. Moreover, in order to get the
exemption,counterpartieswillhaveanincentivetotradeinliquidQFCs.
2) QFCsthatareilliquid—orpotentiallyilliquid(suchasrepocontractsonMBSs)—
shouldbesubjecttotheordinaryrulesofbankruptcyincludingtheautomaticstay.
The systemic risk underlying fire sales would be avoided, especially given that
complex, illiquid transactions are more difficult to unwind. Of course, this would
comeatthecostofgeneralliquidityofthecounterpartiesandimpacttheirabilityto
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