Let me first talk about market-based mechanisms as a form of prompt corrective action. I think that we have to acknowledge that heavy-handed regulation that focuses on what activities institutions can and cannot do runs the risk of firms devising ways of getting around the rules, forcing activities into the unregulated sector and creating risks elsewhere. Regulators can also find themselves behind the curve as financial markets evolve and innovation changes the way firms function. Discretionary supervision and regulation alone are not sufficient to prevent excessive risk-taking or prevent future crises. Thus, I think reform must seek ways to strengthen market discipline rather than seeking to override or replace markets in controlling risk-taking.

How should we structure this resolution process? While a number of details would need to be worked out, let me provide a broad outline of how it might be done.  First, public authorities would be directed to declare any financial institution insolvent whenever its capital level falls too low to support its ongoing operations…

Next, public authorities should use receivership, conservatorship or “bridge bank” powers to take over the failing institutions and continue its operations under new management…

Shareholders would be forced to bear the full risk of the positions they have taken and suffer the resulting losses…

All existing obligations would e addressed and dealt with according to whatever priority is set up for handling claims…

There is legitimate concern for addressing these issues when institutions have significant foreign operations. However, if all liabilities are guaranteed, for example, and the institution is in receivership, such international complexities could be addressed satisfactorily.

I believe that we need a special receivership process for investment banks that is outside the bankruptcy process, just as it is for commercial banks and thrifts. The reason goes back to the public versus private interest.

The bankruptcy process focuses on protecting creditors. When the public interest is at stake, as it would be here, we need a process to protect it. This process must achieve two central goals. First, it should minimize any public loss and impose losses first on shareholders and general creditors. Second, it must allow continuation of any systemically significant operations.

As I've previously suggested, the FDIC's authority to act as receiver and to set up a bridge bank to maintain key functions and sell assets offers a good model. A temporary bridge bank allows the government to prevent a disorderly collapse by preserving systemically significant functions. It enables losses to be imposed on market players who should be at risk, such as shareholders. It also creates the possibility of multiple bidders for the bank and its assets, which can reduce losses.

The authorities that the FDIC has are a good model, but there are still many open issues...

[T]he Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, took major steps toward reducing moral hazard in the banking system and limiting taxpayer losses by reinforcing the importance of strong capital.  Among the mechanisms in the act is the requirement that bank supervisors take prompt corrective action when depositories show signs of becoming troubled.  This step was reinforced by the least-cost requirements of FDICIA, which generally require the FDIC to resolve a failing institution in the manner least costly to the deposit insurance fund.

Finally, Congress should create a prompt corrective action (PCA) policy regime for the GSEs that truly mimics the one that was introduced into U.S. banking law 15 years ago. The idea behind PCA is simple—if a regulated firm holds only a small buffer of capital to protect the firm’s debt holders from loss, it is critically important that the firm face immediate and increasingly stringent restrictions on its activities as its capital dwindles. Otherwise, an undercapitalized firm experiences even stronger incentives to exploit its unpriced real or perceived guarantees.

...The PCA regime has a major advantage for regulators in that they are instructed by law not to engage in regulatory forbearance, the source of some of the problems that eventually led to the collapse of numerous savings institutions in the 1980s and early 1990s. The only way to deal with time inconsistency is to make bailouts unlikely by tying the hands of regulators. Taking away the power to provide a bailout permits regulators to put more pressure on firms earlier. Moreover, in the absence of regulatory discretion, firms know that a bailout requires a successful approach directly to Congress, which might or might not be successful. Uncertainty over congressional action adds to market discipline.