To emphasize a point I made yesterday, we need to think of ending Too Big To Fail (TBTF) as a continuum rather a simple yes-no binary. The process of failing a large financial firm through the Orderly Liquidation Authority (OLA) can go very well, or it could go very poorly. It’s important to understand that the recent GAO report, arguing that the TBTF subsidy has largely diminished, is incapable of telling the difference.
What would make for a successful termination of a failed financial firm under OLA? To start, bankruptcy court would be a serious option as a first response. Assuming that didn’t work, capital in the firm is structured in such a way that facilitates a successful process. There’s sufficient loss-absorbing capital both to take losses and give regulators options in the resolution. There’s also sufficient liquidity, both within the firm due to strong new capital requirements and through accountable lender-of-last-resort lending, that prevents a panic from destroying whatever baseline solvency is in the firm. As a result, less public funding is necessary to achieve the goals.
Living wills actually work, and allow the firm to be resolved in a quick and timely manner. The recapitalization is sufficient to repay any public funding without having to assess the financial industry as a whole. There’s no problems with international coordination, and the ability of the FDIC to act as a receiver for derivatives contracts is standardized and clear in advance, reducing legal uncertainty.
That’s a lot! And it’s a story about what could go right or wrong that is becoming more and more prevalent in the reform community . Let’s chart it out, along with the opposite happening.
Again, from the point of view of the GAO report, these are identical scenarios. Both would impose credit losses on firms. Thus the GAO’s empirical model, scanning and predicting interest rates spreads to imply credit risk, picks up both scenarios the same way. Whether OLA goes smoothly or is a disaster doesn’t matter. But from the point of view of taxpayers, those trying to deal with the uncertainty and panic that would come with such a scenario, and the economy as a whole, the bad scenario is a major disaster. And we are nowhere near the point where success can be taken for granted. Tightening the regulations we have is necessary to making the successful scenario more likely, and the apparent lack of a subsidy should not distract us from this.
 Note the common similarities along these lines in the critical discussion of OLA from across the entire reform spectrum. You can see this story in different forms in Stephen Lubben’s “OLA After Single Point of Entry: Has Anything Changed?” for the Unfinished Mission project, the comment letter from the Systemic Risk Council, Too Big to Fail: The Path to a Solution from the Bipartisan Policy Center, and the “Failing to End Too Big to Fail” report from the Republican Staff of the House Committee on Financial Services.