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

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I.Introduction Systemicriskcanbedefinedbroadlyastheexpectedlossesfromtheriskthatthefailure of a significant part of the financial sector leads to a reduction in credit availability with the potentialforadverselyaffectingtherealeconomy. 2 Thereareatleasttwocontestingviewson thecausesofsystemicrisk.Inthesocalledmicroprudentialview,thesystemicriskarisesfrom contagionofthefailureofafinancialinstitutiontotherestofthefinancialsector.Asshort termcreditorsofaninstitutiondemandimmediacyagainstitslongtermassets(“run”),short termcreditorsofinterconnectedorsimilarinstitutionsmaydemandsuchimmediacytoo.In contrast, in the socalled macroprudential view, the systemic risk arises from the collective failure of many financial institutions because of their common risk factor exposures. In this view,whenshorttermcreditorsofaninstitutiondemandimmediacyagainstlongtermassets, thereisadisruptiverunonlyifotherinstitutionsareunabletoacquirethelongtermassetsat fairvalues;inparticular,ifinstitutionshavecorrelatedexposures,thenotherinstitutionsare potentially facing runs too and assets must be sold at firesale prices, resulting in disorderly liquidations,potentialallocationinefficienciesandageneralincreaseintherateofreturnon savings(whichcaninducehoardingbehaviorandcutbackonrealsectorlending). Althoughthesetwoviewsarenotmutuallyexclusive,muchoftheregulatoryreforms takeoneviewortheother.Inthemicroprudentialregulations,thefocusisonthesystemically importantfinancialinstitutions(SIFIs)whereasinthemacroprudentialregulations,thefocusis (also) on the risk of a crisis in the financial sector and its spillover to the economy at large. Takingthemicroprudentialview,boththeDoddFrankWallStreetRegulationandConsumer Protection Act (DFA) signed into law by President Obama in July 2010 in the U.S. and, internationally,BaselIIIfocusonsinglefinancialinstitutions. SIFIs consist of financial intermediaries that are not only commercial banks taking deposits and making loans, but also include investment banks, money market funds, mutual funds,insurancefirmsandpotentiallyevenhedgefunds,whosefailureposesasystemicriskto the financial system. This systemic risk can come through multiple forms which include counterparty risk on other financial institutions, asset liquidations that can produce a depressing effect on asset prices, liquidity hoarding that raises funding costs in interbank markets even for safe firms, and an information contagion effect resulting in a significant reductioninoverallmarketliquidity.Therefore,anymechanismsetupbytheregulatorstodeal with the insolvency of SIFIs must follow at least four basic principles (Acharya, Adler, RichardsonandRoubini,2010): 1) ThecounterpartyriskoftheSIFIsmustbecontainedthroughregulationsincluding the imposition of capital requirements, margin rules, and limitation on risky investmentsexante. 2 ThisdefinitionisbasedonAcharya,Pedersen,PhilipponandRichardson(2010).See,forexample,Kaufmanand Scott(2003)forotherdefinitions. 2
2) There needs to be a procedure for dealing with large amounts of illiquid assets whoseforcedsalescanhaveacatastrophiceffectonthefinancialsystem. 3) Theresolutionmechanismshouldbeabletoidentifyinsolventinstitutionspromptly as they can become pockets where financial resources of the economy can get trapped,potentiallycreatingfundingproblemsevenforotherwisesolventfirms. 4) Theremustbewelldefinedrulesforwhathappenstotheliabilitiesofthefinancial institutionwhenitfails,forotherwisearunonmostoftheinstitution’sliabilitieswill occur,potentiallyleadingtoasystemwiderun. Furthermore,sincemanySIFIsoperateacrossborders(globalSIFIs–GSIFIs)and,aswehave witnessed in the recent financial crisis, their failure can threaten the integrity of the entire globalfinancialsystem,totheabovefourprincipleswemustadd: 5) The national resolution mechanisms should be amenable to easy international coordinationfortheeffectiveresolutionofGSIFIs. When the collapse or near collapse of such financial institutions as Bear Stearns, LehmanBrothers,AIGandthelikeaftertheonsetoftheglobalfinancialcrisisin2007madethe inabilityoftheexistingresolutionmechanismstodealwiththefailureofSIFIsclear,theU.S. wasthefirstmoverwiththeDoddFrankAct.Toaddresstheconcernsabouttheinabilityofthe existing resolution mechanisms to handle the failure of SIFIs, Title II of the DFA created the OrderlyLiquidationAuthority(OLA)asanewmechanism.However,asitisstatedfairlyclearly inTitleIIoftheDFA,theOLAisnotaresolutionbutliquidationmechanism. 3 Putting aside the question of whether such liquidation – rather than a resolution – authority focusing on individual financial institutions is sufficient to achieve the DFAstated goalsofinducingmarketdisciplineandmitigatingmoralhazard,thequestionofwhetherthe OLAcanaddressthesystemicriskassociatedwithsuchsystemicallyimportantmarketsasthe saleandrepurchaseagreement(“repo”)marketorsuchsystemicallyimportantsectorsofsmall institutionsasthemoneymarketmutualfundsremainsdebatable. 4 Althoughwediscussour concerns regarding the OLA in the next section in detail, let us give a simple example from September,2008,toillustratehowtheOLAmayfailincontainingthesystemicrisk: After the Lehman Brothers’ bankruptcy filed on September 15, 2008, its outstanding debt collapsed in price almost immediately. Since one of the largest money market mutual funds(MMMFs),theReservePrimaryFund,washighlyexposedtoLehmanBrothers'collapsing shortterm debt, the next day its net asset value (NAV) fell below par. Since MMMFs offer stableNAVandinvestorscanredeemanytimeatpar,animmediaterunontheReservePrimary 3 HR4173,TitleII,“OrderlyLiquidationAuthority,”Sec.204,“OrderlyLiquidationofCoveredFinancialCompanies.” 4 See,Acharya,Adler,Richardson,andRoubini(2010)andAcharya,Cooley,Richardson,andWalter(2011)for detaileddiscussions. 3
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