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Financial Planning > Behavioral Finance

Consultants: Prefunding Bailouts Could Promote Bad Behavior

By Arthur D. Postal

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WASHINGTON BUREAU — Prefunding a resolution authority that would be used to wind down large, troubled financial institutions “may encourage the same irresponsible behavior that gave rise to the economic crisis,” Promontory Financial Group L.L.C. says in a new paper.

The American Council of Life Insurers, Washington, commissioned Promontory, Washington, to prepare the paper.

Promontory, an economic consulting and research firm, says using assessments on financial firms to put cash in a “systemic dissolution” fund for large, failing financial institutions would hamper economic growth and be unfair to participating financial firms.

Prefunding a systemic dissolution fund also could promote riskier activity among financial institutions, Promontory says.

Promontory released the paper as Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking, Housing and Urban Affairs Committee, continued to work on a financial services bill. Some say the bill could come out next week.

A draft released in December 2009, the Restoring American Financial Stability Act of 2009 draft bill, would permit assessments only after the systemic resolution fund receives a claim.

H.R. 4173, a bill passed by the House, would require the fund administrator to assess large financial firms before incurring any dissolution costs.

If financial institutions put money in the fund in advance, market participants may think of the existence of the fund as a partial guarantee and engage in riskier-than-normal behavior, Promontory says.

Neither a post-funded fund nor a pre-funded fund would expose taxpayers to any risk of footing the bill for a systemic failure, Promontory says.

“Although a post-funded regime would necessarily entail either borrowing from the taxpayers or a public auction of Treasury securities backed by the taxpayers, the industry would eventually repay these funds with interest,” Promontory says.

“The experience of the state insurance guarantee associations and the Financing Corporation (FICO) in collecting long-term post-event assessments from the insurance and banking industries, respectively, offers no reason to doubt the efficacy of a post-assessment regime in protecting the taxpayers,” Promontory says.

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