The debate over what to do about too-big-to-fail is heating up (see here (FRB) and here (BoE) and here (Simon Johnson for a summation and commentary).  A lot of the moves in the
debate are well-rehearsed:  the
moral hazard issues involved with too-big-to-fail have been amply noted
elsewhere, and the problems with having firms create “living wills” that
specify wind-down procedures is fairly self-evident—it is simply too hard for
firms to predict the state of the world at the time a wind-down would be
necessary, so firms might be committing themselves to suboptimal action.

I think it is important, however, to draw attention to a
serious defect in proposals for a special resolution system for large
systemically important firms. 
There is simply no way to regularize a resolution system for too-big-to-fail
institutions because they cannot be resolved without the commitment of
government funds, and provision of government funds is a political decision
that cannot be decided ex ante. 
The nature of too-big-to-fail resolution is inherently political and
locked into a preexisting system. 

Resolution of financially distressed firms is at core a
distributive exercise.  There isn’t
enough money to pay everyone on time. 
Therefore, some creditors won’t get paid according to the original terms
of their obligations.  Some won’t
get paid in full and some won’t get paid on time and some won’t get
either.  Deciding who has to take
their lumps is a distributive decision, and that sort of decision is inherently
political. 

For regular firms or non-systemically important financial
institutions, we avoid having to deal with the politics of distribution on a
case-by-case basis through a statutory system that allocates risk in
advance.  Parties largely know
where they will stand in the event of bankruptcy or bank insolvency and can
deal accordingly ex ante.  This is
one of the great strengths of regular insolvency systems. 

It cannot work, however, for too-big-to-fail institutions
because resolution of a too-big-to-fail institution requires government funds,
and provision of government funds is a political decision that cannot be
decided ex ante both because of the way appropriations work and because the
distributional questions are likely to be particularly sharp and nasty with
systemically important institutions. 

The problem with too-big-to-fail institutions is not the
institution itself—no one really cares about the distressed firm qua firm. 
Instead, the concern is about the distressed firms’ counterparties and
the impact its failure will have on them. 
Sometimes the problem is from the ubiquity of counterparties and
sometimes it is from the particular identity of counterparties.  In either case, the goal in resolving a
systemically important institution is to protect a particular set of
counterparties.  Who those
counterparties will be, however, will vary by systemically important
institution.  In one case it might
be payment system creditors, in another it might be brokerage creditors, in
another it might be bondholders, in another it might be secured lenders, and in
another it might be unionized employees or retirees.  The unpredictable nature of the counterparties we want to
protect means that distributional questions cannot be pre-set, and that makes
them political issues, especially when the government has to provide active
funding for the resolution.

Resolving a financially distressed firm of any sort requires
funding, whether a bridge loan to a sale or liquidation or financing for a
reorganization.  There are many
financially distressed firms that are able to get private bridge loans until
they can sell themselves or otherwise work out their problems.  To the extent that a financial firm,
however large, can obtain such private funding, there is no need for a special
legal resolution procedure.   A special resolution procedure might provide buyers of
the firms’ assets with special protections, like a 363(f) sale in bankruptcy,
but if I had to guess, lack of a free and clear sale order from a court or
agency probably wouldn’t be the dealbreaker. 

Thus, a special resolution procedure is only really needed
when a private resolution is not possible either because of (1) the lack of
assets available as collateral for new loans, (2) the scale of the failed
enterprise, or (3) the speed of the enterprise’s collapse, which makes due
diligence for lending impossible. 
A formal resolution procedure alone can only help with situation
(1).  It is of no help in
situations (2) or (3).

In situation (1) a priming lien procedure, such as in
364(d)(2) of the Bankruptcy Code, would allow for new money to be injected even
if all assets were already committed as collateral.  To be sure, there very few contested priming liens granted
in bankruptcy, and in bankruptcy, at least, existing secured creditors still
have to get adequate protection, which might not be possible in all cases.  Moreover, a priming lien is only
possible when there is collateral value left.  If the firm’s assets are worthless, they will not support a
secured loan. 

A formal resolution procedure is of no help in situation (2)
because the sheer size of the failed firm is so large that sufficient private
funding is not available.  Is there
enough private capital that could be readily assembled to provide a bridge loan
to JPMorgan Chase, for example?  If
not, then there is only one choice—the lender of last resort—the
government.  Likewise, in situation
(3), private capital might be available, but not on such short notice.  There are too many questions about the
failed firm’s finances for lenders to commit.  The solution to this is to provide some sort of a
third-party guaranty for the new financing, but where would this come from
except the government. 

Thus in most failures of too-big-to-fail institutions, the
government will have to provide funding for the resolution, and this makes the
resolution a political issue.  For
this reason alone, I think we are kidding ourselves if we believe that we can
regularize the resolution of systemically important institutions.  It would be great if we could regularize
too-big-to-fail resolution, but I don’t think it is possible to come up with
any set of rules that we won’t break at the first sign of them creating
distributional results that we do not like. 

So where does this leave us?  We could avoid the too-big-to-fail problem to some degree by splitting off riskier business lines (investment banking) from the systemically important ones (commercial banking–payments and deposits).  There isn't a lot of political appetite for this fight, however; the administration has made clear it isn't going to get into this mother-of-all-banking-regulation-battles.  So that means we're are going to have to learn to live with too-big-to-fail.  The administration believes it can regulate its way to safety.  I hope so, but worry that the nature of regulation in most cases is to play catch-up and it is often politically influenced.  Moreover, I'm not sure that all of the implications of too-big-to-fail have been thought through.  Allowing too-big-to-fail institutions has profound consequences on housing finance for example (good-bye GSE funding advantage…).  And having too-big-to-fail institutions means, at core, that the credit of these institutions is the credit of the national government.  Thus BoA, Chase, Citi, and Wells will be extensions of the US government.  UBS will be an extension of the Swiss government, Deutsche Bank of the German government, etc.  I wonder if this points toward some sort of neo-mercantilism….