Treasury and Barney Frank have released their draft legislation on "too big to fail" (TBTF), which includes a special resolution authority, a council of regulators that will monitor systemic risk, heightened prudential standards for systematically important financial institutions ("Tier 1 FHCs"), and a "prompt corrective action" regime for Tier 1 FHCs. Easily the most important proposal in the Treasury/Frank plan is the resolution authority for systematically important financial institutions. (The resolution authority starts on page 164 of the discussion draft.) There's much to like in the proposed resolution authority—although I must say, it has a rather peculiar structure, with the whole receiver/qualified receiver thing. Obviously, the press will love the Systemic Resolution Fund, which is required to recoup the costs of any future bailout from financial companies with more than $10 billion in assets. (The administration's previous proposal had similar language, by the way.) Of course, I still see several problems—bankruptcy is still mandatory for "critically undercapitalized" Tier 1 FHCs, for some bizzare reason. In this post, I want to talk about the proposal's treatment of OTC derivatives and other "qualified financial contracts" (QFCs). This is a critically important issue, and Treasury and Frank get it mostly right. QFCs have long been exempt from the automatic stay in bankruptcy, which means that when a financial institution files for bankruptcy, its counterparties can immediately seize and liquidate the collateral they were holding against the QFCs (e.g., Treasuries, Agency MBS) to recoup their losses. In normal times, this is good policy, because firms use QFCs for things like dynamic hedging. However, when Lehman failed, the QFC exemption was a disaster. Every Lehman counterparty—which included practically every major financial institution in the world—seized and liquidated collateral at the same time, sending asset prices plunging across the board. The Treasury/Frank proposal treats QFCs the same way the FDIC does when it resolves a failed commercial bank. There's essentially a one-day stay on QFCs, during which time the FDIC can transfer the failed institution's QFCs to a healthy third-party acquirer or a bridge bank. But if the FDIC transfers one QFC with a certain counterparty, it has to transfer all of that counterparty's QFCs, or none at all. Once the one-day stay on QFCs expires, counterparties to any QFCs the FDIC didn't transfer can seize and liquidate the collateral. (In practice, the FDIC always transfers all the QFCs.) The reason I said the Treasury/Frank proposal gets QFCs "mostly right" is because it fails to distinguish between cleared and non-cleared QFCs. Clearinghouses have their own procedures for transferring a failed clearinghouse member's QFCs to healthy third-party members. Clearinghouses are also in the best position to quickly take stock of a failed member's outstanding trades and to quickly transfer them to the right institutions. So what the resolution authority needs to do is exempt "cleared QFCs" from the one-day stay, and let the clearinghouses take care of transferring those QFCs to third-party acquirers. The FDIC would still be in charge of transferring non-cleared QFCs, like repos, which would still be subject to the one-day stay. To be perfectly honest, I would extend the stay to 3 days, since we already know that the QFCs we'd be talking about are extremely complex, and potential third-party acquirers would need a little more time to examine the failed institution's derivatives book. ICE Trust (the main CDS clearinghouse) has a 3-day period for transferring contracts to other clearing members, for example. All in all, though, Treasury and Frank get an A- on QFCs.

2 comments:

babar ganesh said...

i haven't had the chance to go through this, and it's complicated. has anyone written a basic roadmap/ outline of the legislation?

Anonymous said...

The reserve fund, whether before tax or after tax dollars, will be paid for by the taxpayer. I do not like having big piles of cash lying around. They distort the economy, and in a negative way. They have their own moral hazard.