Speed bankruptcy expert Garett Jones on how to cure “too big to fail.”
Last week I had a chance to interview Garett Jones, a professor of economics at George Mason University and the BB&T Professor for the Study of Capitalism at the Mercatus Center, on the pending financial regulation reform bills and the recent financial crisis.
Earlier this year Jones wrote a paper, published by Mercatus, that proposed an alternative to bailouts and the financial regulation bills for dealing with troubled banks: speed bankruptcy. The simplified idea behind speed bankruptcies is that failing banks would be subjected to procedures very similar to Chapter 11 bankruptcies, with shareholders getting wiped out and bondholders becoming the new shareholders. What would make these bankruptcies “speedy” is that the terms for this procedure would be written into the banks’ bonds, meaning that during a crisis the bonds would automatically convert to equity stakes in the bank once regulators decided that the bank had failed. The goal of such convertible bonds would be to remove uncertainty about regulators’ decision-making and prevent discretionary bailouts, and also to recapitalize endangered banks.
I asked Dr. Jones about the fallout from the bailouts of 2008, how to prevent bailouts in future financial crises, and the possibility of speed bankruptcies as an alternative to the current regulatory reform legislation’s “resolution authority” that would give federal regulators the ability to take over and wind down financial institutions in crises.
We now have financial regulation reform bills from the House and Senate. What are your general thoughts on the reform legislation?
I have to say, the resolution authority in the bill is not the worst thing I can imagine. I’m so used to politicians doing the worst thing I can imagine that this is a pleasant surprise. They’re getting about a third of what I think would make up a sound anti-bailout policy. They certainly have taken some steps in the right direction.
How well does this bill address the problem of banks being regarded as too big to fail?
I think the bill moderately reduces the problem of too big to fail. It doesn’t totally reduce the problem. Let me start off with what I think is the best part first.
The best part is the “funeral planning” provision that they’ve required in the bill — every few months, every big financial institution in the country is going to have to show the government its plans for how to dismantle it in the event of a financial crisis. So it’s a little bit like the bomb maker saying “here’s how to diffuse my bomb.” It’s a little bit like BP saying, “If we build this platform, and there’s a catastrophic collapse, here’s how we’ll cap the well.” Because banks are going to have to make these plans, and present them during nice calm economic times, I think that the government regulators will actually probably be willing to really say no to the banks, and say, “No, this isn’t a good enough plan. We’ll give you six months or a year to fix it, but if you haven’t given us a real plan for how to dismantle you if you go bankrupt, then we’re going to force you to shrink. We’re going to force you to sell off the weirdest, most difficult to bankrupt parts of your firm.”
During a crisis, everyone’s in favor of a bailout. No matter what they say verbally, they’re still going to walk down to the floor of the Senate or the House and vote for a bailout. But during periods of calm we might be able to structure the big financial institutions so that we’ll have a better shot at preventing them from becoming un-bankruptable. So I think that’s a key strength of the plan.
Right now firms don’t have to do this at all. They can just do whatever they want to and they can create a web of financial networks that are so complicated that voters, regulators, and politicians are all terrified of the prospect of sending these firms to a bankruptcy judge, or the FDIC. I think that making plans during a period of calm is a little bit like making the plans for a house — planning the fire sprinklers or the fire escapes during a nice calm time rather than deciding in the middle of the fire, “OK, here’s how we’re going to get people out of the building.”
If banks make funeral plans in advance, does that make regulators at the Fed or one of the proposed new agencies redundant? Or do they still have discretion over whether banks get bailed out?
That’s a huge problem. The question is, they can spend a lot of time creating these plans, but when the crisis hits will they cave, will they get weak in the knees like Paulson and Bush did?
That’s really the big question. That’s why I think there have to be five or six different ways built into our political system to make sure we don’t dive back into bailouts. The funeral planning is one. I think the rest is a lot weaker… much, much weaker.
There is this resolution authority in the bill, which basically says that the government will have the authority to take over a big financial institution just as the FDIC does now, and in a way just as a bankruptcy judge takes over a firm when it goes bankrupt. So they’ll have that authority — the question is will they use it or will they get scared again like they did last time?
Personally, I think there’s nothing in that resolution authority that couldn’t have been hammered out in the two weeks it took to write the TARP. I don’t think it was outdated bank regulations that was keeping us from letting Citigroup fail. The absence of a resolution authority was not the big deal.
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