Tyler Cowen has a piece in the NYT today arguing that regulatory reform won’t work unless creditors are exposed to the risk of some loss in the event of counterparty failure.

Mr. Cowen suggests that the simple solution of letting creditors make their case in bankruptcy court isn’t workable because of the cost to the economy (too big to fail, I assume) and the fact that after Lehman it is not politically feasible. Instead he advances two alternatives.

Here is one possibility. The government has restricted executive pay at A.I.G. and banks receiving government funds, but this move fails to recognize that the richest bailout benefits go to creditors. Restricting compensation at these creditor firms would have more force — if it is done transparently, in advance and in accordance with the rule of law. A simple rule would be that some percentage of bailout funds should be extracted from the bonuses of executives on the credit or counterparty side of transactions.

Such a rule would make lenders more conservative, which would generally be a good thing. To make sure that this measure doesn’t choke off economic recovery, a workable plan would impose compensation restrictions only after the economy improves and banks are recapitalized.

Here is another option: Even in good times, when there is no threat of insolvency on the horizon, credit agreements should provide for the possibility of a future, prepackaged bankruptcy. Those agreements should require that the creditors themselves would suffer some of the damage — even if the government stepped in to bail out the afflicted firm.

There is a risk that these sacrifices will not be extracted when the time comes, but the prospect might still check the worst excesses of leverage.

I suppose that either proposal might have some effect on the margin among market participants but I also think that he is correct in assuming that when the next crisis comes their is quite a good chance that they wouldn’t be enforced.

Beyond that, this seems like a proposal the end result of which would be a set of rules so complex that they would fairly beg to be gamed. To the extent individuals might see compensation clawed back there might be a built-in incentive to accelerate bonuses and job hop in order to insulate oneself from potential liability. Creditors that know in advance that they might be on the hook for a piece of the loss in the event of failure would surely find some means to hedge that exposure. That daisy chain could make the AIG fiasco look like small potatoes.

As with most things in life, simple is always better. Instead of searching for elegant solutions, the system needs to be redesigned to allow for the expedient of bankruptcy. This necessarily means that “too big to fail” has to pass into history. We should have by now learned that the large highly complex system that was allowed to develop is too dangerous. It needs to be redesigned so that failure is a real possibility. When that happens counterparties will pay attention.

more: here