Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

On Monday, at the end of a long day of wrangling over technical details at the Federal Deposit Insurance Corporation’s Systemic Resolution Advisory Committee, Paul A. Volcker cut to the chase. The resolution authority created by the Dodd-Frank financial reform legislation was a distinct improvement on the previous situation, making it easier to handle the failure of a single large financial institution.

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It does not, however, end the myriad problems associated with that most daunting and modern of phenomena: too big to fail.

At age 85, Mr. Volcker, the former chairman of the Federal Reserve, speaks softly and displays a razor-sharp mind. The room where the committee met was hushed as everyone leaned forward to catch his words. Mr. Volcker incisively observed that the general legal framework of Dodd-Frank, as currently being put into effect, definitely puts more effective powers in the hands of the Federal Deposit Insurance Corporation to handle the failure of what is known as a systemically important financial institution.

But the bigger issue is a point made by Mr. Volcker and others at the table. When big banks boom, they find new ways to finance themselves and, too often, regulators go along. The assets they buy look like a sure thing until the moment they collapse in value. This is the classic and future recipe for systemwide panic and potential collapse. The only solution to prevent this is to limit the size of the largest institutions and the activities they can undertake.

The F.D.I.C. has long had the powers necessary to handle the failure of a bank whose deposits it insures. It can take over such an institution, sell off the viable parts of its business and place the remainder in a form of liquidation, so that as much asset value as possible is recovered. Management and boards of directors are immediately let go (with no golden parachutes). Shareholders are typically wiped out – meaning that the value of their shares falls to zero, as it would in the case of bankruptcy. Creditors to the original company also suffer losses – with the full extent determined by how much value the F.D.I.C. can recover; again, a close parallel with bankruptcy, but the F.D.I.C. is in charge, not a bankruptcy court judge.

Sometimes this kind of F.D.I.C.-managed process is referred to as nationalization – in fact, that is the term the White House used to describe this option in early 2009, when it was proposed that Citigroup, Bank of America and other large bank-holding companies should go through a form of F.D.I.C. resolution. But nationalization is a complete misnomer and President Obama was poorly advised when he used the term.

The F.D.I.C. operates state-of-the-art bank resolution processes. Depositors typically do not lose access to their funds for even five seconds – and that includes all forms of electronic access. And the reason we want the F.D.I.C. to do this is simple: it prevents the kind of disruptive bank runs that previously plagued the United States and that helped make the economy of the 1930s so depressed.

The question for the modern financial world, however, is not so much how to handle the failure of small and medium-size banks with retail deposits. The specter that haunts us – in the form of Lehman’s bankruptcy and the bailouts provided subsequently to other large firms – is how to handle the imminent collapse of large nonbank financial companies.

The F.D.I.C. is now central to a process that can take any kind of financial company through resolution. The Federal Reserve and the Treasury are also involved, and safeguards are in place to prevent capricious action. These may sometimes delay action.

But the F.D.I.C. unquestionably now has the legal authority and practical ability to impose losses on shareholders and creditors of the holding company. It has also embarked on an ambitious outreach program to explain that the goal is to allow operating subsidiaries to keep functioning, in the hope of minimizing the disruption to the world’s financial system. (Big banks are now organized with a single holding company owning and controlling a large number of operating subsidiaries.)

No taxpayer money is supposed to be put at risk in this situation. Shareholders in the holding company will be wiped out. Creditors will find their debt converted to equity, typically involving a reduction in value. This new equity forms the capital base of the continuing company – meaning its obligations are restructured so that it is again solvent (meaning the value of its assets exceeds the value of its liabilities).

Creditors to operating subsidiaries would suffer losses only if there were not enough debt at the holding-company level – in other words, after reducing all that debt to zero (converting it entirely into equity), the company’s liabilities still exceed its assets.

Together with Sheila Bair, the former chairwoman of the F.D.I.C., and other colleagues, I wrote to the Federal Reserve Board earlier this year, impressing upon them the importance of ensuring there is enough debt at the holding company – relative to potential losses at the operating subsidiary level. I was disappointed to learn on Monday that the Fed is still a considerable distance from issuing even a proposal for comments on this important issue.

In addition to Mr. Volcker, among the other heavyweights at the table were Anat R. Admati of Stanford, Richard J. Herring of Wharton, David Wright of the International Organization of Securities Commissions and several experienced practitioners.

Big banks do not typically fail individually. More often, there are herds that stampede toward a particular issue or fad: emerging-market debt (1970s and 1990s); commercial real estate (United States, 1980s); residential real estate (United States, Spain, Ireland, Britain, 2000s); sovereign debt (Europe, 2000s).

These banks finance themselves with short-term wholesale money – creating the impression that this is safe, when in fact it is incredibly precarious (think Iceland in 1998 or the exposure of American money-market funds to European banks as recently as 2011.) In any truly dangerous boom, markets and regulators become equally infatuated with this new way of doing business – until it collapses.

Can the new resolution authority handle the next big wave of potential failures, whatever it might be? Probably not, even with the greater level of cooperation announced on Monday of the F.D.I.C. and the Bank of England, with an eye to handling cross-border resolution of difficulties between the two nations, which could be immense considering how our big banks operate.

If it is built well and works properly, a good resolution framework allows a company to fail, without socializing losses and without destabilizing the financial system. As a result, it will provide a level of market discipline that should lessen the herd mentality of taking on the kind of risks that create a systemic problem – and the next big wave of failures. But the primary lesson from F.D.I.C. planning and our discussions is this: no resolution framework can correct a systemic problem once it has occurred.

The United States needs multiple fail-safes. As Professor Admati has been arguing, we should rely on equity – not debt – to absorb losses in our financial system (see this comment letter). In addition, I stand with the original intent of the Volcker Rule and with the current position of Thomas Hoenig (the current vice chairman of the F.D.I.C.): in addition to stronger resolution powers and much more equity capital, the size of the largest financial institutions should be capped and the activities they can undertake limited.

Article source: http://economix.blogs.nytimes.com/2012/12/13/volcker-spots-a-problem/?partner=rss&emc=rss