By Steven K. Beckner

Plosser acknowledged potential problems with the use of market
triggers, but remarked, “the regulators’ ability to commit to their own
form of prompt corrective action is also a major concern and is likely
to have consequences for asset prices.”

Plosser agreed with the report’s recommendations that an insolvent
financial institution should be dismantled and its parts sold off and
that the resolution process should be as predictable as possible.

“Regulatory authorities should not be able to use discretion to
alter contractual claims in the resolution process,” he said.

But Plosser said the resolution process should be left to the
courts, not the regulators.

“I believe a bankruptcy court with special procedures for financial
institutions would be better equipped than a bank regulator to credibly
dismantle large financial institutions without bailouts,” he said,
adding, “I do not view an initial vetting by a panel of judges, as
outlined in the Senate bill, as a substitute for a real bankruptcy court
proceeding.”

Plosser called “sensible” the report’s proposal to place higher
capital requirements on brokerage accounts that permit collateral to be
reused by the broker-dealer and lower capital requirements on accounts
that fully segregate the customers’ collateral.

He also seconded their questioning of current law’s special
treatment of qualified financial contracts, such as repos and
derivatives contracts.

“Under current law, these contracts are exempt from the automatic
stay in a bankruptcy proceeding; that is, counterparties can take
immediate possession of their collateral when a financial firm enters
bankruptcy,” he noted. “Other claimants without this special treatment
must wait until the court has worked out a plan.”

Plosser maintained that “this special treatment actually increased
systemic risks during the recent crisis.”

“Sophisticated counterparties were encouraged to provide short-term
repo funding, collateralized by securities that turned out to be very
illiquid, such as various asset-backed securities,” he elaborated.
“These creditors clearly perceived that they did not need to carefully
monitor their borrowers’ condition, in part, because they expected that
they could seize collateral before other claimants.”

“In turn, this created incentives for the borrowing firms to
increase leverage, and increase their reliance on short-term funding,
which increased fragility in the financial system,” he added.

Plosser said he believes “we should limit the special treatment in
bankruptcy to a much smaller group of contracts, such as those repos
secured by highly liquid collateral (cash or Treasuries).”

“For short-term funding secured by collateral with more uncertain
value, sophisticated counterparties should have the incentive to look
more carefully at the borrower’s risk of default,” he said. “The
consequence may be that short-term funding collateralized by securities
other than cash or Treasuries might become more expensive and less
pervasive.”

Plosser said this might make the financial system “a little less
fragile.”

The Squam Lake Report came down strongly in support of living
wills, and Plosser agreed that all systemically important should be
required to “have a plan for their own bankruptcy as well as an estimate
of how long this bankruptcy would take. Higher capital requirements
would be assessed for firms whose bankruptcies would take longer.”

But Plosser said “firms will not have a strong incentive to
cooperate without pressure from regulators.” So he suggested that “we
might use the conversion of a firm’s convertible debt as the occasion
for requiring firms to begin serious planning for their ultimate
bankruptcy.”

“Once a firm has been declared undercapitalized, the regulators’
bargaining power to insist on a serious plan for bankruptcy will be
greater,” he said. “For these firms, I would argue that regulators
should also consider a more aggressive approach to press systemically
important organizations to simplify their internal structure.”

He said “a joint exercise in which the regulator and the financial
firm prepare for bankruptcy would certainly be a useful tool.”

Although Congress is expected to enact reform legislation before
long, Plosser closed by saying that, as far as he’s concerned, “I don’t
think that Congress’s approach is necessarily the final word on
designing a resolution mechanism that will end the problem of firms that
are too big to fail.”

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