The Case for an Orderly Resolution Regime for Systemically-Important Financial Institutions

The Obama Administration has proposed that the government be given special authority to resolve a nonbank financial institution if its failure could have serious systemic effects. This new Orderly Resolution Regime (ORR) is needed because the existing regime confronts US economic and regulatory authorities with two very unappealing options: allow the institutions to go into corporate bankruptcy, thereby accepting the associated systemic risk, or to weigh in (often over a weekend) with a large government rescue.

Arguments that this new ORR will be over-used and will increase moral hazard are weak for four main reasons. First, the expansion of the (de facto) official safety net that occurred during this crisis took place without any ORR in place. Second, appropriate safeguards have been proposed that should limit its use. Third, as proposed, it is not clear that an ORR will necessarily weaken market discipline and, finally, while the Systemically Significant Financial Institution (SIFI) distinction is often described as similar to the Government Sponsored Entity (GSE) distinction, the latter actually represents a unique set of circumstances.

The chief counter proposal to the ORR, an amendment of the existing corporate bankruptcy code, suffers from four potential flaws. First, corporate bankruptcy is focused almost exclusively on the interests of creditors of the firm, with little concern for "third party" effects such as systemic risk. Second, the restrictions on the claims of creditors inherent in bankruptcy will likely result in counterparties (and employees) refusing to do business with a financial institution either in or approaching bankruptcy. Third, court proceedings are likely to move slowly, as opposed to administrative proceedings like an ORR. Finally, whereas the ORR would permit the government to intervene in various ways before the firm "fails," traditional corporate bankruptcy would not.

Other important considerations include the proposal that any ORR should have a dual mandate (both to seek a least-cost resolution and to minimize adverse spillover effects), provide a system of prompt-corrective-action (PCA), and cover any SIFI not subject to the FDIC's resolution authority. The decision to discuss whether the ORR should be used should be initiated by the firm's prudential regulator or the market stability regulator, with the decision to activate the ORR vested in the Treasury, subject to certain additional requirements. Any ORR should be funded from an assessment and on a pre-arranged line of credit from the Treasury, with the FDIC acting as the operational resolution authority.

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