Chris Papagianis of e21 is concerned about the Dodd bill:

The Democrats’ “resolution authority” proposal needs to be thought of in two discrete time periods: the “crisis” period, when the firm is on the verge of collapse, and the “ordinary” period when the firm is able to access external funding and otherwise function normally.

He goes on to explain the dangers involved in offering TBTF banks guarantees through a resolution fund, a subsidy that could exacerbate financial instability.

The question facing every lawmaker is whether creditors would feel more or less secure about their investment in a large financial firm if they were informed that a $50 billion bailout fund (and tens of billions of dollars more, if necessary) stood ready to make them whole in the event of default? Viewed in this light, it is clear that if two institutions were otherwise identical in terms of their asset quality and risk profile, a creditor would prefer to invest in the debt securities of the “systemically significant” institution thanks to the added layer of protection afforded by the bailout fund. As a result, even if “resolution authority” improved current law by allowing for the orderly liquidation of failed financial institutions during the crisis period, this benefit would come with the cost of subsidizing the borrowing of larger institutions during the ordinary period. These subsidies could also destabilize the financial system if they create merger incentives or encourage systemic firms to issue more debt. In a fascinating paper, researchers at the Federal Reserve Bank of Philadelphia estimate the value of the too-big-to-fail (TBTF) subsidy using merger data. They find that deals involving banks whose combined size would exceed $100 billion post-merger – roughly the threshold to be included in the Fed stress tests – involved premiums of nearly $2 billion per deal. In short, this $2 billion was the price the acquiring institution was willing to pay relative to other acquisitions to exceed the $100 billion threshold and attain “systemically significant” status. And achieving this status was based on mere speculation; once the newly created “Financial Stability Oversight Council” formally defines which firms are “systemically significant” the TBTF subsidy would likely rise because the uncertainty about whether the firm was covered under the bailout umbrella would be removed.

As an alternative, Papagianis calls on Congress to embrace the Hart-Zingales proposal, outlined in the latest issue of National Affairs, with an important modification.

While Hart and Zingales choose the right instrument for their trigger, their proposed remedial step should be strengthened. Instead of having the regulator demand that the institution issue new equity, the debt of the institution could automatically convert into equity. Say a large bank financed $150 billion of assets with $80 billion of deposits, $40 billion of senior debt, $20 billion of so-called junior debt, and $10 billion of equity. When the CDS on this bank surpassed the critical threshold, half of the bank’s junior debt would automatically convert to equity. Instead of having 6.7% equity (15-to-1 leverage), the bank’s assets would be financed with 13.3% equity (7.5-to-1 leverage). If that failed to bring the CDS below the critical threshold, the other half of the junior debt would also convert to equity. The mandatory conversion would enhance systemic stability for two reasons. First, the risk that the debt would convert to equity would be priced into the debt, raising the systemic institution’s cost of capital and leveling the playing field with smaller banks. Secondly, the automatic conversion would eliminate the potential for regulatory forbearance caused by market conditions. When a number of banks are distressed at the same time, it may not be possible for all of them to issue enough equity to drive their CDS below the critical level. Regulators may allow the firm to wait until conditions improve or otherwise work to coordinate stock offerings. In the meantime, the threat to the institution and the financial system could grow. Mandatory conversion eliminates this risk by ensuring the bank’s equity capital ratio can automatically increase to the desired level even under the most stressful market conditions.

Please send your thoughts: I’m curious to see if there are any weaknesses in this proposal, or any virtues of the Dodd approach that I’m missing.