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E-MailSteven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law and Senior Fellow at the Centre for International Governance Innovation. This post is based on his recent paper.
Since the financial crisis, regulators have been shifting their focus from traditional microprudential regulation, which protects individual banks and other financial firms , to “macroprudential” regulation that protects the stability of the financial system itself. Regulators have begun expanding that macroprudential focus to include bankruptcy “resolution” techniques designed to reorganize the capital structure of, or else to liquidate with minimal systemic impact, systemically important firms that become financially troubled.
To date, however, regulatory efforts to use those techniques to try to protect financial stability have been inadequate, in part because bankruptcy law traditionally has microprudential goals—to protect individual firms that are financially troubled but otherwise viable—whereas protecting financial stability is a macroprudential goal. Much of the current thinking about using bankruptcy-resolution techniques conflates these goals. This paper seeks to analyze the macroprudential goals of resolution, in order to differentiate them from microprudential goals and derive a logically consistent theory of how and why macroprudential “resolution-based regulation” can help to stabilize the financial system.
The analysis begins by examining how resolution-based regulation is being used. There are three general approaches. The first two—referred to as “reactive” resolution and “proactive” resolution—represent resolution in the strict sense of reorganizing the capital structure of, or liquidating, a firm. Reactive resolution is by far the most common approach in the United States and worldwide. It is “reactive” in the sense that it applies when a firm becomes financially troubled. For example, corporate bankruptcy law is designed to reorganize the capital structure of financially troubled firms to make them viable, and to liquidate such firms that cannot be made viable.
For at least two reasons, bankruptcy law may be insufficient to protect financial stability. First, it focuses on protecting individual firms, not on protecting the financial system. That focus is inherently microprudential. The financial crisis showed that multiple systemically important firms can become troubled around the same time, requiring a more aggregate and coordinated response. Secondly, the bankruptcy of Lehman Brothers raised concern that existing corporate bankruptcy law may be ill suited to reorganizing the capital structure of large financial firms. Although that concern has prompted proposals to amend bankruptcy law to better adapt it to those types of firms, the proposed adaptations remain microprudential, following the traditional approach of negotiating an individual firm’s debt restructuring. Even the regulatory-supervised approach to reactive resolution epitomized by the Orderly Liquidation Authority (OLA) is inherently microprudential because it focuses on protecting individual firms.
Some resolution-based regulation is “proactive” in the sense that it consists of pre-planned enhancements that are designed, at a time when a systemically important firm’s default is merely a theoretical possibility, to take effect if the firm becomes troubled—by then strengthening the firm’s ability to pay its debt (and thereby avoid default) or facilitating its resolvability. Proactive resolution is implicitly justified by chaos theory, which recognizes that failures are almost inevitable in complex systems and thus the most successful systems are those in which the consequences of failures are limited.
Proactive resolution-based regulation is currently being applied to systemically important firms in several ways. One such approach, for example, seeks to pre-engineer a change to a systemically important firm’s capital structure that becomes effective if the firm experiences financial problems. Different iterations of this approach have been referred to as total loss-absorbing capacity (“TLAC”) and contingent convertible securities (“CoCos”). In each case, the firm would be required to have a requisite portion of its debt in the form of securities that convert to equity upon pre-set conditions. Conversion would reduce the firm’s indebtedness, thereby (hopefully) making the firm financially viable again. The initial tests of CoCos have had mixed success, however. Furthermore, CoCos can raise their own moral hazard concern, and their use is limited to protecting individual systemically important firms—a microprudential goal.
The third way that resolution-based regulation is being used is “counteractive”: to try to reduce the need for resolution by preventing firms from becoming financially troubled. As such, it does not strictly represent resolution per se. For example, regulation imposing capital and liquidity-coverage requirements is designed to keep systemically important firms solvent and able to pay their debts, thereby reducing the need for resolution. Capital and liquidity-coverage requirements, however, are typical forms of ordinary microprudential regulation. Although counteractive regulation is sometimes discussed as part of the topic of resolving systemically important firms, that goes beyond regulation that is truly resolution-based.
The paper therefore focuses on reactive and proactive approaches to resolution, first identifying their macroprudential goals. Intuitively, regulation that protects individual systemically important firms might appear to protect all systemically important firms; if no systemically important firm fails, no such firm’s failure would trigger a systemic collapse. However, protecting individual firms is insufficient. Among other reasons, correlated triggers can cause the concurrent failure of multiple systemically important firms, overwhelming regulation intended to protect individual firms. Ironically, regulation designed to protect individual firms can even create correlated triggers. To overcome these limitations, resolution-based regulation should be designed to try to protect systemically important firms not merely individually but also in the aggregate.
Even if systemically important firms could be protected both individually and in the aggregate, the failure of other critical elements of the financial system could trigger a systemic collapse. These are the markets that facilitate the issuance and trading of securities, and the financial infrastructure that serves to clear and settle that trading. Resolution-based regulation should also have the goal of protecting those other elements against failure.
The paper next analyzes how to design resolution-based regulation to achieve these goals, using insights gleaned from recognizing that the financial system is a “system.” Systems that are both interactively complex and tightly coupled are prone to catastrophic failure, suggesting that resolution-based regulation should be designed to reduce tight coupling and/or interactive complexity. Resolution-based regulation could reduce interactive complexity, for example, by requiring systemically important firms to disclose more detailed information about their securities holdings and contractual obligations. It could also reduce tight coupling by empowering central bank last-resort lending to illiquid but solvent systemically important firms and to avoid financial market panics. Resolution-based regulation could also help to stabilize systemically important financial markets by requiring circuit breakers that automatically suspend market trading if prices decline too rapidly and by suspending mark-to-market accounting in systemically important markets that become subject to extreme volatility.
Finally, the paper examines how resolution-based regulation could protect systemically important financial infrastructure. Although governments and private organizations have been considering how to protect central counterparties in this infrastructure, they have largely ignored the need to protect the infrastructure’s clearinghouses from undue exposure to affiliate risks. Resolution-based regulation, the paper argues, could provide that protection by ring-fencing the infrastructure and making it bankruptcy-remote. The same reasons that justify ring-fencing public utilities justify ring-fencing clearinghouses: both provide essential public services, have few if any substitutes, and are exposed to affiliate risks.
The complete paper is available for download here.
