Tax Reform and Resolution Authority Are Keys to Regulating Systemic Risk

Reforming the tax code to move it away from favoring debt and leverage towards favoring equity is a component of controlling systemic risk to the financial markets, in the view of Jaime Caruana, General Manager of the Bank for International Settlements. In recent remarks, the GM also said that a resolution regime to wind down a failed financial firm is a critical component of reform. The cross-border nature of many financial institutions calls for harmonized resolution regimes.

Recently, there has been an increasing consensus that tax code reform needs to be part of financial reform. Taxing bigness or interconnectedness in the financial system deserves study. The idea of a financial transactions tax is under consideration, and the Obama Administration has proposed a .

Regarding these tax proposals, one question to be considered is whether the tax would end up being paid by customers, or even by shareholders. Another question is whether higher capital and liquidity requirements for systemic institutions would be as effective as tax incentives.

More broadly, tax policy could be also used to address sectoral developments with potential financial stability implications. For example, tax policy could be used as a tool to limit excessive credit growth in specific areas, such as housing. A key way to ensure that the tax code worked for rather than against financial stability would be to reduce or to eliminate its bias towards debt and against equity. The recent crisis has shown the unfortunate results this bias can have on asset prices and leverage, especially in housing markets. The BIS official reasoned that getting rid of the tax incentive to leverage could make a significant contribution to financial stability.

Another key way to lessen the systemic risk is establishing adequate resolution regimes to hold down the system-wide loss that arises when a large financial firm fails. One key element of such a regime is to ensure that the counterparties of an important firm are not sheltered from loss in the event of failure, noted the official, so that market discipline is strengthened ex ante. This can further help to limit the probability of default.

However, the BIS official cautioned that setting up an adequate resolution regime is no easy matter. One reason for the difficulty is that the legal problems are complex, with the ongoing Lehman Brothers liquidation being an example. The international nature of the :Lehman dissolution also highlights the need for cross-border resolution frameworks.

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.

Financial reform legislation passed last year by he US House would provide for the orderly resolution of cross-border financial institutions, which former SEC Chair Arthur Levitt and former Fed Chair Paul Volcker recently testified 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.

The Administration 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. Instead of subjecting a firm to bankruptcy or simply injecting taxpayers' funds, the legislation would allow for a federal conservatorship leading to orderly reorganization or wind-down.

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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