Although we have a legal framework for dealing with failing institutions, we have learned that, in a crisis, the “systemic spillover” that can emerge from failures of our largest institutions and the threat to the broad economy require additional consideration. The most recent examples of this have led to the suspension of normal bankruptcy and bank resolution processes, thus institutionalizing the concept of too big to fail in our economic system.

Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.⁶   While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.

I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies....I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.

[B]ankruptcy procedures are designed to provide a clear priority among creditors, but do not provide any special provisions for an insolvency that has broad systemic implications. In such situations, it is very possible that a preferable public policy would be to minimize systemic implications rather than follow the normal creditor priority set out in the bankruptcy code.

I have outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis in the United States.  Boiled down to its simplest elements, the plan would require those firms seeking government assistance to put the taxpayer senior to all shareholders with the impact on managers and directors depending on the viability of the firm.  Nonviable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and reprivatized as soon as feasible.

To be sure, a new resolution regime is not panacea. We also need better and smarter regulation. Many of the institutions that got into trouble were already heavily regulated. We didn't do enough to constrain leverage, regulate derivatives, and most important, protect the consumer. We forgot that there is a difference between "free markets", and "free for all markets".

There has been much talk lately about a new resolution process for systemically important firms that Congress could enact, and I would encourage this be implemented as quickly as possible, but we do not have to wait for new authority.  We can act immediately, using essentially the same steps we used for Continental.
Stock could be issued and control assumed by a government entity.  A bridge institution could be created within the institution so essential services and operations would continue as normal.  Where necessary, the government would provide capital in exchange for preferred shares convertible to common stock upon sale.  Existing shareholders would provide the government warrants to purchase all outstanding shares with the amount exercised determined by the government's resolution cost.  Senior management and directors would be replaced.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete.  We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008.  Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm.  The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline.

Both {resolution} models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm. The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption while limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.

The new resolution regime would need to be carefully crafted. For example, clear guidelines must define which firms could be subject to the alternative regime and the process for invoking that regime, analogous perhaps to the procedures for invoking the so-called systemic risk exception under the FDIA. In addition, given the global operations of many large and complex financial firms and the complex regulatory structures under which they operate, any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply to one or more parts of the consolidated organization.

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail"...  In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking.  Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical, analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.

When we consider these consequences it becomes more apparent, to me at least, that we must strive to limit public safety nets and minimize their associated moral hazard problems… To return to my analogy, this means doubling back across the river to a more historical central banking role, and making clear a future crossing would be rare…

If we choose to double back, then we must also direct more supervisory focus to the market interdependencies among commercial banks, and we must institute better mechanisms to unwind failing nonbank financial institutions and their counterparty exposures.  

The liquidity tools of central banks and the emergency powers of other public authorities were created in recognition of the fact that individual institutions, including those central to payments and funding mechanisms, cannot protect themselves fully from an abrupt evaporation of access to liquidity or ability to liquidate assets. The existence of these tools and their use in crises, however appropriate, creates moral hazard by encouraging market participants to engage in riskier behavior than they would have in the absence of the central bank’s backstop. To mitigate this effect on risk-taking, strong supervisory authority is required over the consolidated financial entities that are critical to a well-functioning financial system.

A more resilient financial system will also require a framework for dealing with the failure of financial institutions. For entities that take deposits, we have a formal resolution framework in place...we need a companion framework for facilitating the orderly unwinding of other types of regulated financial institutions where failure may pose risks to the stability of the financial system.

As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.

The details of any such tools and of the associated decisionmaking process require more study. As Chairman Bair recently pointed out, one possible model is the process currently in place under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) for dealing with insolvent commercial banks...

Designing analogous rules for the prompt and orderly resolution of securities firms is not straightforward, as these firms differ significantly from most commercial banks in their financing, business models, and in other ways.  Despite the complexities of designing a resolution regime for securities firms, I believe it is worth the effort.  In particular, by setting a high bar for such actions, the adverse effects on market discipline could be minimized.

Of course, the mere creation of a market stability regulator can increase moral hazard and decrease market discipline. The expectation that a regulator will intervene to protect the system must be limited to the greatest extent possible. In other words, we must limit the perception that some institutions are either too big or too interconnected to fail. If we are to do that credibly, we must address the reality that some are. To do that, we must strengthen market infrastructure and operating practices in the OTC derivatives market and the tri-party repo system and clarify the resolution, or wind down, procedures for non-depository institutions. Creating a more stable environment will mitigate the likelihood that a failing institution can spur a systemic event.

I believe that we need a special receivership process for investment banks that is outside the bankruptcy process, just as it is for commercial banks and thrifts. The reason goes back to the public versus private interest.

The bankruptcy process focuses on protecting creditors. When the public interest is at stake, as it would be here, we need a process to protect it. This process must achieve two central goals. First, it should minimize any public loss and impose losses first on shareholders and general creditors. Second, it must allow continuation of any systemically significant operations.

As I've previously suggested, the FDIC's authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets offers a good model. A temporary bridge bank allows the government to prevent a disorderly collapse by preserving systemically significant functions. It enables losses to be imposed on market players who should be at risk, such as shareholders. It also creates the possibility of multiple bidders for the bank and its assets, which can reduce losses.

The authorities that the FDIC has are a good model, but there are still many open issues...

Both market participants and public authorities should understand that, despite our best efforts, crises are inevitable, and so we need to work on crisis management as well. Here, too, cooperation among authorities here and abroad is critical. We must understand the market structures and vulnerabilities and the objectives and constraints under which authorities with different jurisdictions would be working in those circumstances.

Inevitably, uncertainty on the part of market participants and public authorities will be heightened in the event of market turmoil, and that uncertainty can feed on itself. Both authorities and participants need to think through how they will handle such crises. For the authorities, that process includes considering how to resolve any failures of large institutions in ways that impose costs on shareholders and uninsured liability holders while preserving orderly markets. Such a resolution will be necessary to limit the moral hazard of any interventions that we are forced to undertake. Market participants need to consider how they would settle contracts and work with troubled borrowers in a distress situation. More planning will reduce the rise in uncertainty in a crisis and the likelihood that fear will lead to precipitous actions that are in no one's best interest.