The chairman of the Federal Deposit Insurance Corporation, Sheila Bair, gave a speech today in Istanbul in which she floated a proposal to limit the claims of secured creditors of failed banks. Here is how she put it:
A more far reaching proposal to consider is limiting the claims of secured creditors to encourage them to monitor the riskiness of the financial firm.
This could involve limiting their claims to no more than say 80 percent of their secured credits. This would ensure that market participants always have 'skin in the game'.
This would be very strong medicine.
It could have a major impact on the cost of funding for companies subject to the resolution mechanism.
A major advantage is that all general creditors could receive substantially greater advance payments to stem any systemic risks without the extensive delays typically characteristic of the bankruptcy process.
Obviously the advantages and disadvantages need to be thoroughly vetted.
In any event, there is a serious question about whether the current claims priority for secured claims encourages more risky behavior.
In a recent paper, the Federal Reserve Bank of Kansas City points out that many commonly used short term instruments, such as commercial paper and repurchase agreements, often increase leverage and make firms more vulnerable to illiquidity and insolvency.
By totally protecting secured claims, and many repo claims as nettable financial contracts, the current priority scheme may encourage greater fragility in the financial markets.
A resolution mechanism that discourages this result by potentially haircutting these claims could help reduce dependence on short-term funding and increase firm, and system, resiliency.
A Bloomberg news account of the speech paraphrases an associate professor of economics and law at the University of Missouri-Kansas City, William Black, as saying, "the proposal would probably increase banks' cost of funding and make it harder to find long-term financing because creditors would be watching closely for any signs of trouble." The Bloomberg wire quotes Mr. Black as saying, "It would make it gratuitously more expensive for banks to raise funds, even on a secured basis."
Does Ms. Bair really want to make it harder and more expensive for banks to raise capital? In her speech she frames the haircut-the-secured-creditors proposal as a kind of trial balloon: "Obviously the advantages and disadvantages need to be thoroughly vetted." Wouldn't the time for the Obama administration to thoroughly vet those advantages and disadvantages be before one of the top U.S. bank regulators goes out and gives a speech suggesting it? Otherwise, while the vetting is going on, the specter of such limits being imposed and changing the longstanding legal rights of secured creditors will make it harder for banks to raise capital, and harder for American businesses to get loans. One can argue that easy credit helped cause the bubble and that tightening would be a necessary corrective. But with politicians talking about the need to build confidence and get credit flowing again, implementing Ms. Bair's idea may run counter to at least some of the government's expressed policy goals.
It's worth noting, too, that Ms. Bair, a former aide to Senator Robert Dole, was originally appointed by George W. Bush. So the frustration from the business community at the regulators isn't just partisan anger at President Obama or at the Democrats; in certain circles there is a feeling that Mr. Bush and his team began a series of mistakes that are continuing under the current administration. Of all the regulators, Ms. Bair's credibility is particularly thin, given how she handled Washington Mutual.