The administration's plan for regulatory reform of the financial system includes a proposal that existing government agencies have the authority to resolve failed or failing "systemically important" nonbank financial institutions. In support of this idea, the administration argues that authorizing the government to resolve failing nonbanks financial firms is necessary to assure that these firms are resolved in an "orderly" way. The administration's concern seems to be that allowing a systemically important nonbank financial institutions to enter an ordinary bankruptcy proceeding may be "disorderly," and thus contribute to a systemic breakdown.
Nonbank financial institutions that might be systemically important include bank holding companies, insurance companies, securities firms, finance companies, hedge funds, private equity firms, and any other financial-related firm that might-because of its size, role in the financial system or interconnectedness-- cause a systemic breakdown if it fails.
This note argues that while the terms "systemic risk," or "systemic breakdown" can be defined in words, they cannot be used as an effective guide for policy action. We have no way of knowing when or under what circumstances the failure of a particular company will cause something as serious as a systemic breakdown-as distinguished from a simple disruption in the economy. Government officials' inability to forecast or predict the effect of a particular company's failure will mean that the government will take over or rescue from bankruptcy many companies that should be allowed to fail in the normal way. The effect will be to introduce moral hazard into the financial system, as creditors come to believe that large financial companies will be rescued; the financial system will be weakened as inferior managements and business models are saved from extinction by inappropriate government action; and the taxpayers will be required to bear needless costs.
In addition, a resolution system for nonbank financial institutions is unnecessary to prevent a systemic breakdown because these institutions cannot create a systemic breakdown. A systemic breakdown occurs when the failure of one financial institution causes immediate cash losses to others, rendering them unable to meet their own obligations, and causing losses to cascade through the entire economy. This condition can only be caused by the failure of a large commercial bank, which deprives other banks of the funds they were expecting to be paid, deprives businesses of access to their payroll funds, and deprives individuals of the funds they use for their daily needs. The losses that occur as a result of the failure of a nonbank financial institution are not of this character; they occur over time as obligations that come due are not paid, and affect creditors who are generally diversified, and able to withstand an occasional loss. No business deposits its payroll with a securities firm.
Accordingly, as argued in this note, there is no sound policy basis for providing the government with authority to resolve nonbank financial institutions, and granting such authority would be harmful to the financial system and the economy generally. Instead, failing nonbank financial institutions, both large and small, should be allowed to go into bankruptcy.
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