In my earlier post on TBTF policy, I started to discuss why "prompt corrective action" (PCA) is the key to making TBTF policy work, and I want to expand on that here. Done right, I really do think PCA could be the glue that holds TBTF policy together. The resolution authority is clearly the most important aspect of TBTF policy, since "too big to fail" just means "too systematically important to put into Chapter 11." Give us a resolution authority that can wind down systematically important nonbank financial firms without causing a financial crisis, and suddenly no firm would be TBTF anymore — the TBTF problem would instantly vanish. The trick is obviously to design such a resolution authority. Easier said than done. One of the biggest problems is that there are no trial runs — we won't know whether the resolution authority we end up with actually works (i.e., allows regulators to wind down systematically important financial firms without causing a financial crisis) until we use it during a crisis, which policymakers will be loath to do the first time because it'll still be untested. But that's where PCA should come in. PCA can act as "foam on the runway" for the resolution authority (to borrow a phrase from Geithner). In the earlier post, I argued that one of the PCA triggers should be contingent on the tenor of a financial institution's overall liabilities—that is, the Fed should be required to take prompt corrective action once a large financial institution allows the tenor of, say, 20% of its overall liabilities, or 50% of its daily funding requirements, to drop below one week (again, I just pulled those numbers out of the air). In other words, the new PCA regime should be focused more on a large firm's liquidity ratios than on its capital ratios. What sort of "corrective action" should a financial firm that runs afoul of this or other similar PCA triggers be forced to take? Broadly, I'd say that the PCA regime needs to force a firm to secure a certain amount of medium/long-term financing for its capital markets activities (e.g., $X >30 days, $Y >100 days; "medium-term" and "long-term" are relative terms here, since we're most talking about capital markets positions). The key is to make sure that a systematically important firm's survival or failure is not contingent on its ability to obtain ultra short-term financing. As a firm relies more and more on overnight repos and rehypothecated collateral and prime brokerage accounts to fund its positions, its balance sheet gets exponentially more chaotic and confusing — securities are being pledged overnight all over the place, the firm is rehypothecating all the collateral it can (and some that it can't), etc., etc. If the firm ends up failing, this makes a smooth resolution 100 times harder, in part because of the inevitable delay required to figure out where everything is. Lehman was still transferring assets in between its various European and North American branches at a furious pace right up until its bankruptcy filing. As a result, a lot of hedge funds and other investors were very surprised to discover that their assets were not in segregated accounts in Lehman's North American unit, but in fact had been transferred to Lehman Brothers International (Europe) and then rehypothecated. This was a huge source of uncertainty in the days following Lehman's bankruptcy filing. It was also the main reason why hedge funds all started pulling their prime brokerage accounts from Morgan Stanley and Goldman, which both investment banks had relied on to some extent for short-term financing (the so-called "free credits"). The new PCA regime should aim to prevent this kind of thing from happening by making a large firm's survival or failure contingent on its ability to obtain medium/long-term financing for its capital markets positions, or by giving the Fed the authority to restrict transactions between affiliates once a large firm passes a certain PCA trigger. If we can use PCA to ensure that a large firm doesn't rely more and more on ultra short-term financing as it edges closer to failure, then a successful resolution under a new resolution authority is very realistic. The point is that PCA needs to be a way to force both the financial institution and the regulators to start getting their ducks in a row in preparation for a resolution. If PCA can ensure the conditions necessary for a smooth (i.e., non-catastrophic) resolution of a large financial institution, then we'll have a legitimately "successful" resolution authority for large nonbank financial institutions, and the problem of TBTF will be no more. Of course, I've been through more than enough rounds of financial regulatory reform to know that it's highly unlikely it'll actually happen that way. But getting a framework in place that could get us to that point isn't out of the question, so long as the fairweather populists can be kept in check.