Levitt, Volcker Stress Need for Resolution Authority for Large Financial Institutions; Basel Urges Cross-Border Framework

With the US contemplating legislation establishing the orderly resolution of cross-border financial institutions, and the issue of global coordination of national resolution regimes looming, former SEC Chair Arthur Levitt and former Fed Chair Paul Volcker told Congress that the creation of such a resolution authority is the key to eliminating the moral hazard of too big to fail. In testimony before the House Financial Services Committee, Mr. Levitt said that, in order to address the too big to fail challenge, Congress must provide a legislative process to manage the failure of systemically important financial institutions. The problem is not that financial institutions are too big, he reasoned, but that there is no uniform orderly process to let then fail without causing a market meltdown.

Similarly, Mr. Volcker advocated a new resolution regime for insolvent or failing non-bank institutions, such as hedge funds, of potential systemic importance. He envisions the appointment of a federal conservator to take control of a financial institution defaulting, or in clear danger of defaulting, on its obligations. Authority should be provided to negotiate the exchange of debt for new stock if necessary to maintain the continuity of operations, to arrange a merger, or to arrange an orderly liquidation. In his view, such an authority, preempting established bankruptcy proceedings, would be justified only by the exceptional circumstance of a systemic breakdown.

The senior officials join the growing consensus, shared by the Obama Administration, that the lack of a federal resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises. As demonstrated by AIG, severe distress at global financial institutions can pose systemic risks to the financial markets. Former SEC Chair Levitt warned that allowing market participants to assume that large financial institutions will not be permitted to fail is a dangerous course that will only encourage more recklessness.

Thus, the Administration has asked Congress to pass legislation establishing a new resolution regime for the orderly resolution of failing systemically risky financial institutions, including securities and commodities firms. A federal regulator would manage the resolution of such firms in a manner that limits systemic risk with the least cost to the taxpayer, in conjunction with the primary regulator of the affected institution. The draft authorizes federal regulators to use the same set of tools for addressing distress at non-bank financial institutions as they currently posses to deal with distressed banks. Institutions covered by the proposed legislation would include holding companies that control broker-dealers and futures commission merchants.

Before any of the emergency measures specified in the proposed legislation may be taken, Treasury, upon the positive recommendations of both the Fed and the appropriate primary federal regulator of the firm, and in consultation with the President, must make a triggering determination that the financial institution is in danger of becoming insolvent and that such insolvency would have serious adverse effects on financial stability.Instead of subjecting a firm to bankruptcy or simply injecting taxpayers' funds, the draft legislation would allow for a federal conservatorship leading to orderly reorganization or wind-down. As part of this process, the draft would enable the federal conservator to sell or transfer the assets or liabilities of the firm, renegotiate or repudiate contracts, and address the firm’s derivatives portfolio

There is currently no framework for the resolution of cross-border financial groups or financial conglomerates. At the national level, few jurisdictions have a framework for the resolution of domestic financial groups or financial conglomerates. The global financial crisis illustrates the importance of effective cross-border crisis resolution authority. For example, Lehman Brothers group consisted of 2,985 legal entities that operated in 50 countries, with many of these entities subject to host country national regulation as well as supervision by the SEC.

The Basel Committee recently set forth recommendations on the cross-border resolution of financial institutions. Basel recommends a middle ground approach that recognizes the strong possibility of ring fencing in a crisis and helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders. Such an approach may require discrete changes to national laws and resolution frameworks to create a more complementary legal framework that facilitates financial stability and continuity of key financial functions across borders.

This approach aims at improving the ability of different national authorities to facilitate continuity in critical cross-border operations that, absent such efforts, may contribute to contagion effects in multiple countries, while minimizing moral hazard. This middle approach protects systemically significant functions, performed by the failing financial institution, but not the financial institution itself, at least in its current ownership and corporate structure. It would limit moral hazard and promote market discipline by imposing losses on shareholders and other creditors wherever appropriate.

Encouraging greater cross-border cooperation within such a middle ground approach requires improved understanding of the parameters for action by different authorities and greater convergence in national laws.

An alternative approach, which is not as likely to happen, would be to establish by international treaty a comprehensive, universal framework for the resolution of cross-border financial groups. This would require major changes to national legal frameworks and a harmonization of national rules governing cross-border crisis resolution, including rules on core issues such as a avoidance powers, netting of derivative contracts

At the very least, said Basel, the global nature of many financial institutions requires close cooperation among national authorities. Having similar tools and similar early intervention thresholds may facilitate coordinated solutions across borders. Basel urges national authorities and international groups to monitor developments toward the convergence in these legal frameworks.

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