Corporate'Bankruptcy Code is not effective in times of severe stress'
Timothy Geithner / November 1, 2009, 0:58 IST
During the recent financial crisis, in order to preserve the stability of the financial system, protect the savings of Americans and prevent greater economic fallout, the government was forced to step in and stand behind almost all of these firms. That cannot happen again.
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We believe that the test for any effective set of reforms is whether it has five key elements:
ORDERLY RESOLUTION OF FAILING INSTITUTIONS
First, the federal government must have the ability to resolve failing major financial institutions in an orderly manner, with losses absorbed not by taxpayers but by equity holders, unsecured creditors and, if necessary, other large financial institutions. In all but the rarest of cases, bankruptcy will remain the dominant tool for handling the failure of non-bank financial firms. But, as the collapse of Lehman Brothers showed, the Bankruptcy Code is not an effective tool for resolving the failure of a global financial services firm in times of severe economic stress. The Bankruptcy Code focuses almost exclusively on maximising the interests of a firm"s creditors, with little or no concern for spill-over effects on the financial system or the economy. It often moves too slowly. And it contains too few mechanisms for the stabilisation of critical operations of a failed firm.
Recognising this, the US Congress established a separate resolution regime for banks and thrifts, allowing the Federal Deposit Insurance Corporation (FDIC) to accomplish orderly failures of depository institutions.
The purpose would be to unwind, dismantle, sell, or liquidate the firm in an orderly way that protects the financial system at lowest cost to taxpayers. Shareholders and other providers of regulatory capital of the failing firm would be forced to absorb losses, and managers responsible for the failure would be replaced.
NO OPEN-BANK ASSISTANCE
The second element of effective reform is making sure that any individual firm that puts itself in a position where it cannot survive without special assistance from the government must face the consequences of failure.
The proposed resolution authority would not authorise the government to provide open-bank assistance to any failing firm. The authority would facilitate the orderly demise of a failing firm, not ensure its survival, and would strengthen market discipline and reduce moral hazard risks.
PROTECTING TAXPAYERS FROM LOSSES
The third element of effective reform is making sure that taxpayers are not on the hook for any losses that might result from the failure and subsequent resolution of a large financial firm. The government should have the authority to recoup any such losses by assessing a fee on large financial firms.
LIMITING FED"S AND FDIC"S EMERGENCY AUTHORITIES
The fourth element of effective reform is limiting the emergency authorities of the FDIC and the US Federal Reserve so that they are subject to appropriate checks and balances and can be used only to protect the financial system as a whole.
STRONGER CONSTRAINTS ON SIZE AND LEVERAGE
The fifth element of effective reform is giving the federal government stronger supervisory and regulatory authority over major financial firms, and making sure that key financial markets and market infrastructure have buffers strong enough to absorb losses associated with periods of financial stress. Regulators must be empowered with explicit authority to force major financial firms to reduce their size or restrict the scope of their activities when necessary to limit risk to the system. This is an important tool to deal with the risks posed by the largest, most interconnected financial firms.
To build up shock absorbers system-wide, all firms must face higher prudential requirements. And we are negotiating a new international accord to establish a level playing field for capital requirements.
Finally, we must close loopholes and reduce possibilities for gaming the system.
(Excerpts from the testimony of US Treasury Secretary Timothy Geithner at the US House Financial Services Committee"s hearing on consumer lending in Washington on October 29, 2009)