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

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guidelines in repo market financing (and similarly in other SIALs), they would effectively be subjecttosolvencycriteriasimilartothoseforbanks(andmightnotsurvivecompetitionfrom banksinthefirstplace).Further,whiletheprimaryriskcontrolinGortonMetrickschemeis through restriction of eligible collateral for safe harbor provisions, safe harbor is in principle eliminatedfromourreporesolutionauthorityanditjustconditionallyhappenstobeakinto safeharborinsomecasesevenforeligiblecollateral(whendefaultsareisolatedasin6)above). Our proposal also has some similarities to the Federal Liquidity Options proposal of Tuckman (2012b) which recommends that central banks presell liquidity options as the exclusivemeansoflendingmoneytononbankinginstitutionsinacrisis.Theideaofreducing theriskofthelenderoflastresortthroughpaidforcommitments,andtherebyminimizingthe expostsocializationofresidualrisks,isinsimilarspiritasourproposal.Thedifferenceisthat ourapproachalsoproposesamechanismtomanagetheresidualrisksnotbackedbythelender oflastresort(orthereporesolutionauthority)oncetheexantecommitmentshavebeenmet (paymentsbeyondconservativehaircutsaremadewithimmediacy). Finally,BlissandKaufman(2011)proposerefinementsoftheOLAundertheDoddFrank Actthatwouldapplyregularbankruptcyproceedingstofailingfinancialfirmsbutwithadvance payments to such firms upon failure (“modified debtorinpossession (DIP) financing”) and mandatorybutlimitedhaircutstoall“protected”(e.g.,safeharbored)creditors.Bothofthese refinements also feature in our proposal, as immediate liquidity provided by the repo resolutionauthoritytoclaimsinfailureandthecreditriskonunderlyingcollateralbeingpassed ontotheclaimsinduecourse.Thekeydistinguishingfeatureofourproposalisthatitgrants therightstolargescaleassetliquidationstotheresolutionauthorityinordertoaddressthe issueofdisorderlybankruptcyorfiresaleswhenthefailureofaninstitutionisnotinisolation butiscoincidentwithotherregulations. Itisimportanttodiscusswhatwouldhappentorepocontractsoncollateralthatisnot eligible under the repo resolution authority and its strict guidelines and requirements. This wouldconstitutethehypothetical“shadowbanking”inaworldofreporesolutionauthorities. Theserepocontractswouldnothaveaccesstosafeharborandwouldbeperceivedasexante riskierandoflowerliquiditybyfinanciers.However,thiswouldnotnecessarilyguaranteethat financiersinternalizetheexternalitiesofrunsintheshadowbanking.Toguardagainstthis,the reporesolutionauthorityshouldonaperiodicbasisassessifaclassofrepoclaimshasbecome large enough and the underlying collateral is suitable quality enough to be eligible for repo resolutionauthority’sLOLR.Ifyes,theyshouldberequiredbylegislationtobemovedoutof shadowbankingintothereporesolutionauthority.And,wheretheunderlyingcollateralisnot of adequate quality or repo contract class sufficiently small in size, a minimum haircut (or overcollateralization) requirement should be imposed, akin to FDIC’s proposed haircut on all reposoramorerisksensitiveschemesuchasbankcapitalrequirements.Ideally,thehaircut schemeshouldbecountercyclicalandcertainlynotprocyclical(thatis,notprovidetoolowor nonexistenthaircutsingoodtimes,suchasonMBSwithlowqualitymortgagesorgovernment bondreposwheregovernmentcreditriskisnontrivialasintheEurozonesince2008). 30
Havinghighlightedthevariousbenefitsofourproposedapproachsuchasitsflexibilityin extending to new asset and liability classes over time and the difficulty of gaming it by the financialsectorsinceitoperatesforallinstitutionsparticipatinginagivenassetorliabilityclass, wenotethatitdoes–liketheDoddFrankActandtheOLA–relyonacertainamountofability oftheregulatorstogetthingsright.Inparticular,theapproachreliesonregulatorstobeable toestimateconservativevaluesofcollateralwhichnecessitates(perhapsincentivizes)themto ensure sufficient transparency of prices in underlying asset markets in normal times. The approachalsoreliesonadequateincentivesfortheresolutionauthoritytoadoptexanterisk controls in the form ofhaircuts, concentrationlimits, andeligibility restrictions on collateral, among others. While the approach can be harmonized internationally in a relatively straightforwardmannerifsuchcontrolsareharmonized,competitionformarketsharesacross borders can potentially put downward pressure on the adoption and the extent of these controls in practice. For this reason, besides the fact that the lenders of last resort such as centralbankswouldultimatelyhavetostepinwhentheseauthoritiesdonothaveadequate liquidity to make conservative payments, the lenders of last resort would need to act as watchdogsoverourproposedresolutionauthorities,preventingaracetothebottomintheir riskcontrols. V.AHistoricalPrecedent:TheGlassProposal As Graeber (2011), and Reinhart and Rogoff (2009) documented, banking crises have beenubiquitousthroughoutrecenthistoryandonecommonproblemtoalmostallhasbeen thelossofliquiditytobankdepositors.Inthewakeofoneofthesecrises,namely,thebanking panicof1907,theNationalMonetaryCommissionoftheU.S.establishedbytheCongressin theAldrichVreelandActof1908–prepareda19questionquestionnaireandmailedtovarious representativesoftheU.S.bankingindustry(Kaufman,2004).Oneofthequestions–the18 th – asked: 30 “Woulditbewell,inyouropinion,tochangetheexistinglawssothatliquidatingbanks could,insomeway,arrangetopaydepositorsmorerapidly?Acarefulexaminationof theassetsoffailedbankswillshowabouthowmuchdividendtheycaneventuallypay, andconsiderabledistresswouldbepreventedifsomethingapproximatingthisamount couldbepaidtodepositorswithoutanydelay.” AsKaufman(2004)reports,“(r)esponseswereobtainedfrom85respondents.Ofthese,63,or sometwothirds,favoredachangetopaydepositorsofclosedbanksmorerapidly.Thispercent wasthesameamongbankersandbankexaminers,thetwolargestgroupsofrespondents.Only 12respondents,or14%wereopposedtosuchachangeandtheremaindereitherskippedthe questionorwereundecided.” AswementionedintheopeningofSectionII,acentralobjectiveoftheDFAistocreate a new resolution mechanism for nonbank SIFIs and bring them within the FDIC insurance 30 AsquotedbyKaufman(2004),p.243 31
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