More on the Resolution Authority Headfake  Yves Smith  Naked Capitlism

The Powers That Be insist that a magic bullet called a special resolution authority will solve many of the problems with the "heads I win, tails you lose" taxpayer backstopped financial system with inadequate oversight. The prospect of taking terminally sick banks out and shooting them will supposedly reintroduce moral hazard and make banks behave responsibly again.

The problem is that there isn't much evidence to support this optimistic belief. Investment banks were seen as normal enterprises, at risk of bankruptcy, before the meltdown, yet that did not prevent Bear, Lehman, and Merrill from getting themselves into trouble that ultimately proved fatal. And the leaders of these enterprises did not take meaningful financial hits (oh yes, they were less rich than they would have been otherwise, but none of them is at risk of spending his waning years subsisting on dog food), a lesson surely not lost on other bank CEOs.

Then we have the wee problem that the idea of a special resolution authority looks not credible. We've harped more than once that as long as the firms crucial to debt markets remain deeply connected to each other, the idea that one can be taken out gracefully without impacting the others is a fairy tale. We'll believe this comforting story only if we see measures to cut back counterparty exposures, most importantly in the repo and credit default swaps markets.

Bob Teitelman, editor of The Deal, gives a more detailed evisceration of the problems with the idea (I'm jealous that I didn't write this myself):

   The absence of resolution authority has become as handy an excuse for the mess as any, like the lack of a League of Nations after World War I.....Resolution authority, in short, is the Maltese Falcon of regulatory reform. What is this strange bird? Simply put (though nothing here is simple), it's the legislative authority to wind down a financial firm. In fact, this definition is about as far as anyone ever gets on the subject....In its grandiose form (as if its normal form isn't ambitious enough), the mere presence of resolution authority will scare the crap out of stockholders, creditors and counterparties and make them do their job, which is insuring that banks don't go all suicidal, blow themselves up and force regulators to do their jobs....

    But something about resolution authority feels too good to be true. Resolution authority is modeled after the Federal Deposit Insurance Corp.'s power to deal with failing banks. That's fine, but when was the last time the FDIC tackled a promiscuously interconnected, global, highly leveraged giant? Given that we seem to have no idea how finance is wired, how can we be sure that we can halt contagion from spreading from a firm rotting faster than a day-old corpse?....Resolution authority might even trigger self-fulfilling prophecies -- setting off an early scramble for the exits, while regulators are still watching the feature. And what about overseas assets?....

    Who believes that if Goldman, Sachs & Co. was flaming out, the feds would not flinch? Answer: no one with a measurable IQ. Resolution authority resembles proactive bubble defense: The optimal time to use it is before the anticipated corpse turns blue. But if Paulson had shuttered Lehman right after Bear collapsed, would he be praised, pilloried or prosecuted like a dog? Lehman would have howled, Congress would have whined, so try door No. 3. Resolution authority demands, well, resolution in the face of a spitting mob. And yeah, money; no free lunch here. To make it fly requires a hero -- Volcker played that role once on inflation -- willing to lose everything. Alas, such lunatics are rare, making resolution authority just a dusty prop from an old movie.

Yves here. Aside from pointing out the obvious, glaring operational issues, Teitelman points out that there is a massive political problem: for resolution authority to prevent contagion, the sick financial firm probably has to be taken out and shot relatively early. Look how quickly Bear went into a death spiral, a mere ten days. Paulson, who was famously aggressive (like it or not, it did take nerve to put Fannie and Freddie into conservatorship) stepped back on Lehman (this seems to have been in part collective frustration of the officialdom team when the Barclays rescue was blocked by the FSA, of having not been prepared for that deal to fail, but it was also clear at the time that Lehman was not going to be rescued, that the bad press on Bear meant the next firm that foundered would not be helped).

Resolution authority would have to be able to quickly untie the Gordian Knot. Cutting might not do. But a start would consist of the authority to seize all assets of the regulated company in whatever country they reside. Kinda hard to do unilaterally. Second best might be to require the unwinding of all Credit Default Swaps that are NOT written around an insurable interest. We are in the position of a surgeon who knows that surgery might kill the patient, but that the cancer will quickly kill the patient anyway, absent the surgery. Just announcing a rule could trigger a stampede, but at least it would end the suspense. At best it might force people to be responsible or risk losing everything.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."