Repeal of liquidation tool would be a major unnecessary error
   
by: Lawrence Summers
    
 
Inevitably, Congress has more attractive uses for new funds than it has sources of new funds, so there is always is a desperate search for “pay-fors” — measures that are scored by the Congressional Budget Office as raising revenue or reducing outlays and thus can be used to finance new initiatives.

The pressure is particularly acute this year with the ambitious plans of the Trump administration.

There is also the likelihood that the use of the reconciliation procedure will preclude careful deliberation of proposed pay-fors.

I recently learnt of a particularly dangerous pay-for that may have superficial appeal — the repeal of the Orderly Liquidation Authority. This repeal if enacted will exacerbate moral hazard, impair financial stability, increase economic vulnerability and in all likelihood increase the national debt. It would be a major unforced error.

The OLA is a new bankruptcy-type provision included in Dodd-Frank that gives the Federal Deposit Insurance Corporation the authority to resolve insolvent systemic financial institutions (think future Lehman-like episodes). It allows the FDIC to borrow funds from the Treasury to support the liquidation of such firms with the proviso that in the event of any losses, fees will be levied on bank holding companies and other financial institutions to fully reimburse the Treasury. This authority is a wholly rational response to the gaping hole in our financial architecture evinced by the catastrophic Lehman failure, where policymakers’ only alternatives were uncontrolled bankruptcy or taxpayer-financed bailout. Had it been in place in 2008, much carnage could have been avoided.

So, much is wrong with eliminating OLA in order to get about $20bn in CBO-blessed revenue.First, the claim that repeal of OLA will improve the federal budget is bogus. As just noted, it ignores entirely the possible exacerbation of a future economic downturn. Moreover, it does not take proper account of the fact that the law requires that the Treasury be reimbursed in full for any losses. The apparent cost occurs only because the CBO measures budget impacts within a 10-year window and if, for example, a liquidation takes place in year nine, then the reimbursement will take place outside the 10-year window. In the economically relevant present value sense OLA by construction has no budget cost.

Second, without OLA there is much more risk of a future Lehman that will have cascading consequences for the financial system and the economy. Even now, as Natasha Sarin and I have demonstrated, bank market equity values are very low by historical standards relative to total assets, so insolvencies cannot be ruled out. This risk is magnified if, as now seems likely, many of the regulatory protections contained in Dodd-Frank are repealed. Note that if the lack of the OLA causes a future financial crisis to reduce GDP by even 0.5 per cent for one year, the loss of tax revenue will exceed the CBO’s 10-year estimate of the cost of the OLA.

Third, there is the problem of moral hazard. In the absence of a framework for handling liquidation, the pressure will be increased for adhoc guarantees or other measures in time of crisis that prevent creditors from taking losses. The Fed will be under more pressure in its use of the discount window, for example. Congress may be under pressure to authorise taxpayer-financed bailouts. Creditors will believe that if nonpayment to them will set off cascading contagion, authorities will find ways to keep them whole. This will ultimately raise risk-taking and make future crises more likely as “too-big-to-fail” is restored as a possibly self-fulfilling prophecy.

Congress should and will debate proper policy for dealing with failed financial institutions. My own sense is that we are in more danger of having too few tools than too many, for reasons Tim Geithner has recently spelled out in Foreign Affairs. But there are many considerations to be weighed and reasonable people can disagree. What would be wildly unreasonable would be to prejudge the debate and undermine financial stability. I hope that cool heads will prevail and the idea of using OLA repeal as a pay-for will be abandoned.

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