Daniel Tarullo, a member of the Federal Reserve Board, spoke earlier today at the Fed Conference in Washington DC about the progress that has been made in developing a special resolution mechanism for large financial institutions. Nearly five years since the Troubled Asset Relief Program (TARP) first got started, he says the development of the special mechanism is one of the unheralded accomplishments of the post-crisis regulatory environment, even though it is still a work in progress.

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Fed’s program key features

The Orderly Liquidation Authority in Title II of the Dodd-Frank Act gave the outline for the special resolution mechanism, but left many details for regulatory agencies to hash out. According to Daniel Tarullo, the final program will need three key features if it’s going to succeed.

“The first key feature of Title II, simply put, is speed,” said Daniel Tarullo. He mentions that many major decisions during the crisis were made in the course of a weekend, and if another large crisis hits then the reaction will need to be just as fast if it is going to keep markets from spiraling out of control.

Second, there has to be “a source of immediate funding to continue essential functions and minimize the kind of fire sales,” that put pressure on similar assets held by other financial institutions. For a systematically important financial institution (SIFI), that will almost necessarily be a huge sum of money, so the FDIC will be able to draw on a line from the Treasury.

FDIC’s close-out rights

Finally, the FDIC has to have the authority to call a temporary stay of close-out rights while it decides whether it wants to establish a bridge company or work with another, still solvent financial institution.

Daniel Tarullo on Fed’s new program

But encompassing all this, Daniel Tarullo explains that the process has to be clearly delineated and well understood so that markets can properly account for the new risk. A confusing or poorly laid out process could cause some traders to overestimate the amount of risk faced by U.S. financial institutions. What’s even more worrying is that it could cause them to write off the risk completely. In order to be successful, markets need to believe that the special resolution mechanism could actually be implemented, and that once Dodd-Frank is fully in effect, no one is too big to fail.