Earlier this week, Barbara Rehm in the American Banker quoted me doubting the prospects for meaningful action on the FDIC’s orderly-liquidation authority (OLA), lending credence to those who think TBTF has traction. Several of you made clear your differences with this position, arguing that Dodd-Frank does indeed dispel TBTF. For good measure, Treasury Secretary Lew yesterday stood by the U.S. position: OLA works if only we will all be patient. So, why I am now so ornery on orderly liquidation? In short, there’s an array of daunting challenges that must be overcome – and quickly – if OLA is to earn the street creds needed to prove that it’s the cure to moral hazard initial advocates – myself very much included – had hoped.
As Barb says, protestations from Treasury, the FDIC, and FRB notwithstanding, the resolution regime has a long way to go before its construct can be counted upon. Mr. Lew in fact highlighted one major issue: cross-border resolution. He promised to crack heads next year to make other nations see OLA our way – good luck. Given how hard it is for the EU even to agree within itself on what to do, I fear the prospects for cross-border harmony on complex cross-border resolutions are uncertain and far off.
And, even if I’m unduly pessimistic here, there are other, perhaps even more formidable challenges to conquer for OLA to work as Dodd-Frank demands. Making OLA operational is hard enough in contemplation of big-bank failures, especially cross-border ones. But, OLA must work for SIFIs even if banking is only a sideline. Three-plus years later and we’re no closer to anything like OLA for broker-dealers within big banks or on their own. Same goes for large insurance companies except to the extent state guaranty associations cover certain policy risk. Do we know how to shutter a SIFI that holds client assets – i.e., a hedge fund or asset manager? The global Financial Stability Board has proposed protocols for these firms, but as our analyses of the standards makes clear, making these resolution protocols operational is a long-term challenge that along the way redefines affected firms. As a result, we are not only a long way from cross-border resolution for big banks, but also still farther from any construct for SIFIs with significant non-banking activities. This is critical not just for these non-banking firms, but also for the largest banks. The FDIC’s preferred resolution protocol – single point of entry (SPOE) – is predicated on having enough debt and capital at the holding company level to shutter the top-tier firm and recapitalize key subsidiaries. Which ones? How? The FDIC knows how to handle failure in a good-sized insured depository and it thinks SPOE will solve it for bigger firms. But, will it if the big insured depository in the big BHC has large outstanding intra-group exposures to non-bank affiliates? Will living wills map these out so clearly that all the pieces can be put into a newly-capitalized whole? Maybe, but not yet, especially since the wholesale-debt requirements needed to recapitalize the subsidiaries are a long-term work in progress. And, even when the standards are released, there’s no certainty that capital markets will have the capacity to handle all this new debt, especially if SIFIs can’t take it on.
These problems aren’t the only ones bedeviling OLA. Two important other concerns are the ability of SIFIs, especially big BHCs, to arbitrage OLA by down streaming risk to subsidiary firms. FRB Gov. Dan Tarullo says this can be side-stepped if SIFIs issue internal bail-in debt. How? How much? To whom?
And then there’s the automatic-stay challenge – derivatives counterparties under current contracts can run for the hills if the FDIC uses SPOE to establish a bridge holding company. The agency, in concert with several other global regulators, recently implored the industry to revise contractual terms to put counterparty interests second to their own. Don’t wait up.
Does all this doom OLA and, thus, make TBTF the fact of life industry critics contend? No. As Secretary Lew rightly said, Dodd-Frank has a strong, clear, and express prohibition on using taxpayer money to bail out big banks and any other giant financial-services firms that run aground. As he said, Dodd-Frank also has tough new living-will standards that require SIFIs – starting at least with big banks – to figure out how to put themselves to sleep. In a period of relative financial calm, we have a bit of time to let all this play out. But, it won’t last – indeed, we can’t count on it even now.
So, for all Mr. Lew’s steadfast support of OLA, wishing won’t make it so. For all the FDIC’s work on SPOE, talking about it won’t’ make it meaningful. For all the FRB’s assertions about new wholesale-debt restrictions, something has to be proposed or nothing will count. All of these agencies also need to figure out how to demand that big banks hold ever higher amounts of high-quality, secured assets to meet counterparty and regulatory demands at the same time they want loads of unsecured debt at the parent to recapitalize whichever subs are deemed SIFIs when bad things befall the parent. Making SPOE operational for big banks and SIFIs is hard enough on its own, but it can’t work without unintended consequences if its impact on all the other rules underway for these same institutions are not considered in concert with OLA’s build-out. For one thing, the more demands we make on big banks to hold uneconomic amounts of assets, the greater competitive force we endow on shadow banks that will renew systemic risk in ways OLA can’t yet even contemplate.
Hard trade-offs are required by the agencies and, for that matter, by the industry. It can’t just say TBTF is over without agreeing to tough contractual terms on automatic stays and simplifying or even ring-fencing operations to make OLA plausibly operational. Crises will test it and, perhaps find orderly liquidation wanting – battle plans are famously good only until the first shot. But, at the outset the plan has to be plausible. So far, OLA isn’t a plan, just a good law, a lot of hard work by the agencies, and a whole lot of hope.