Last night, House Republicans tried to strike the orderly-liquidation provisions from
Dodd-Frank on the quixotic grounds that the legal bail-out ban perpetuates too big to fail.
At least for now, repeal won’t work. But, the issue remains a potent one because
legislators and many in the market remain convinced that, no matter what the law says,
big banks remain immutable. And, as long as the too-big-to-fail belief persists, big-bank
break-up, ring-fencing, and activity prohibitions are a potent force. Thus, it’s an urgent
priority from both a market-integrity and industry self-protection perspective to scuttle
TBTF once and for all. In recent weeks, the FDIC has taken a major step forward with a
new big-bank resolution plan, and The Clearing House contributed time and dollars to an
industry effort to shut down one of its own without collateral damage. But, more needs
to be done and done fast to prevent roll-back of the best parts of Dodd-Frank.
First, to the FDIC’s latest effort to craft a resolute resolution regime without resort to
taxpayers. On December 10, it announced an agreement with the Bank of England that
outlines the steps each would take if a cross-border G-SIB hits the wall. Although the
Financial Stability Board is still dithering over whether single point-of-entry (SPE) or
multiple points-of-entry (MPE) is the right global protocol, the U.S. and U.K. have
settled on SPE.
In broad terms, SPE means that, if bankruptcy is deemed too risky, the home-country
regulator of the parent of a G-SIB (and, perhaps, even a non-bank G-SIFI) would shut
down the company at the top-tier level. This would eviscerate equity-holders, discipline
“culpable” management and use the firm’s long-term debt to recapitalize operating
subsidiaries to keep the lights on until the bank can be broken up and sold back to private
investors. The best – or, at least the easiest, analogy is the way airlines go into
bankruptcy, where shareholders take a bath while planes stay in the air.
Conceptually, SPE is very robust. But, practically speaking, there are several pieces of
unfinished business that must be finalized before SPE can be represented as the hoped –
for termination of too-big-to-fail. First up among these to-dos is for the U.K. to give the
Bank of England the statutory authority it needs to do all it has promised in SPE. And,
while they’re at it, the U.K. could do something about deposit insurance. Unless or until
Britain has an industry-paid scheme to support ordinary depositors at a failed bank,
taxpayer support under stress remains an all-too-real prospect.
But, it’s not the U.K. with more to do to make SPE a reality. If SPE is to work as
desired, there has to be enough long-term debt to provide reasonable assurance of ready
recapitalization. Figuring out how much debt is enough has yet to begin. To make it
happen, the FRB and FDIC should quickly issue a conceptual advance notice of proposed
rulemaking to solicit analytics and advocacy on this critical question. From this, a final
rule with a reasonable transition period should be issued ASAP.
The FRB and FDIC also need quickly to turn to an important unanswered question in the
SPE agreement: how to handle stays for counterparty contractual agreements. Under law
in both the U.S. and U.K., these contracts have automatic protection from the insolvency
proceeding – that is, the counterparty is protected ahead of everyone else. This is needed
to prevent market panic, but it also perpetuates TBTF for sophisticated counterparties
who bet on credit default swaps or other contracts related to systemic firms. The Fed
took a pass on figuring this out in 2011, despite a request from Congress that it do so.
This too must go back on the ASAP to-do list.
And, one more not-so-easy task: figure out if SPE works as desired in all systemic-risk
scenarios. The FDIC/Bank of England approach, like a lot of industry work, is premised
on a liquidity crisis at a G-SIB. If this is indeed the case, then recapitalization stands a
good chance. If it isn’t, it might not. SPE expects that a G-SIB under solvency stress
would be spotted by regulators, remedied or resolved in an orderly way through ordinary
bankruptcy. That’s a big assumption right there, but an even more speculative one if the
G-SIB is suffering from the lethal mix of solvency and liquidity stress seen in 2008.
What happens under operational risk – that is, when a G-SIB hits the skids because of
reputational risk or a systems failure?
So, more to do on SPE. All of this work is hard and some of it will force painful
decisions on the biggest banks. But, it’s an urgent task now, since the more SPE is built
out before Congress comes back, the more robust the defense against dangerous repeal