Wall Street Interruptus: Why "Resolution Authority" Won't Avert the Next Financial Bubble

Last Updated Apr 26, 2010 5:25 PM EDT

We're in the year 2015, and Wall Street is panicked. China's economic meltdown has put JPMorgan Chase (JPM), which used a new type of derivative to bet heavily on rising growth in Asia, on the verge of collapse. In Washington, President Obama convenes the nation's top financial enforcers, including U.S. Treasury Secretary and former JPMorgan CEO Jamie Dimon, to decide on the best course of action.

On paper, it's a no-brainer. Under a law passed five years earlier, banking regulators can invoke "resolution authority" to shut JPMorgan, thereby keeping the crisis from infecting other parts of the financial system. Indeed, Obama, former Sen. Chris Dodd, D.-Conn., and other financial reformers had hailed this new tool in 2010 in officially declaring an end to the era of "too big to fail."

But does it really? The best test is to ask whether the existence of resolution authority during the crash would've done much to deter large financial reforms from acting recklessly in the first place. There's little reason to think it would. That's because regulators are unlikely ever to use the power even if they have it; and even if they do, it's unlikely to work as planned.

The main argument in favor of resolution authority is that it would give the federal government an option for liquidating large banks besides letting them fail, as the feds disastrously did with Lehman Brothers in 2008, or saving their asses, as they did with the rest of Wall Street. Under this scenario, regulators could've seized, say, Citigroup (C), booted its management, wiped out shareholders and forced creditors to accept losses without crippling the capital markets. Fear of that possibility in turn should encourage those investors and creditors to keep a leash on bank execs.

Advocates of resolution authority think it will help control financial firms' gambling addiction and avert future taxpayer bailouts. And folks like Dodd and Summers -- and Dimon, of course -- have said that establishing an orderly process to wind down the nation's financial firms obviates the need to break up these institutions.

I don't buy it. The problem isn't one of authority, but of resolve. Just as there are many laws on the books that are never enforced, the government has many powers it never exercises.

Take, oh, financial regulation. During the housing boom, the Federal Reserve and federal banking agencies had the means to stop predatory lending, among other practices that inflated the bubble. Trouble is, they lacked the will. They could've ended the party, and they chose not too.

Why? Partly because regulators had rejected the very idea of regulation. Banks over the years also persuaded lawmakers, largely by writing checks, to leave them alone. The reasons matter less than the fact that resolution authority leaves the decision about whether to close a big bank in the hands of people who are often predisposed not to.

Another thing to consider here is that resolution authority does nothing to cure "moral hazard." That's the implicit presumption among investors, bankers and political leaders that the government must rescue large financial firms in order to avoid a larger economic (and political) calamity. It's what allows companies like AIG (AIG) and Goldman Sachs (GS) to roll the dice, since they know Uncle Sam can't afford to let them fail. That same safety net also gives TBTF firms huge competitive advantages, such as lower borrowing costs.

Even with another arrow in the regulatory quiver, in other words, institutions regarded as indispensable the day before financial reform legislation is passed will retain that status the day after. They'll be just as vital to economic stability and just as active in the corridors of power. In short, untouchable.

Indeed, it would be "politically difficult for any president to order a government takeover of an iconic American bank that was insisting through the media and its lobbyists that it was perfectly healthy," write economist Simon Johnson and consultant James Kwak in a new book.

Resolution authority may also be inadequate given big banks' global operations. Seizing JPMorgan would require U.S. regulators to coordinate with their counterparts all over the world. Interests would conflict, since different countries would understandably focus on the impact of the company's failure on them. As a result, financial watchdogs here at home might be discouraged from exercising their due authority for fear of failing to secure international consensus.

Finally, as Johnson and Kwak note, the ability to seize big banks is no guarantee against bailouts. Given these institutions' size and the interlocking gears of the financial system, the Treasury would almost certainly have to tap taxpayers to finance the takeover. So even with a system in place to shutter these firms, they'd blow another hold in the national balance sheet.

Economic history makes one thing abundantly clear: Regulations are like condoms -- vitally important yet still prone to fail. In the end, resolution authority is a prophylactic solution. It may reduce the risk of disease, but it won't keep us from getting royally screwed.

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    Alain Sherter covers business and economic affairs for CBSNews.com.