Earlier today, FRB Gov. Tarullo gave a long-awaited speech on SPOE, the acronym by which the FDIC’s single-point-of-entry resolution plan for the biggest banks has come to be known. Rumors flew that Mr. Tarullo would go beyond his frequent calls for limits on big-bank funding through short-term debt and for specific amounts of long-term, unsecured debt issuances by holding companies, but yet again no details were provided. Indeed, while Mr. Tarullo stood by his long-standing recommendations, he offered several new ones that could either be done in concert with them or perhaps on their own. In short, I still don’t understand SPOE and I don’t know anyone else who does, although a lot of lawyers are trying to write parts of it anyway. One more thing Mr. Tarullo said: if markets don’t believe in SPOE, big banks are effectively too big to fail. He’s right – and it’s time for the FRB and FDIC either to issue proposals or stop talking about them and restructure the industry so they can credibly use Plan B (which stands for bankruptcy).
The stakes here are high, which is why the FRB and FDIC need to act quickly to make SPOE credible. I agree with one other Tarullo comment: bankruptcy as is won’t work for the largest banks because, unlike other large corporations, they are financial intermediaries. This means they transform maturities by taking short-term funds and turning them into long-term assets – the critical functions banks have performed since the early Renaissance. Intermediation means banks don’t just take the solvency risk borne by other companies; they also take liquidity risk, which means they can be cratered quickly in panics sparked by their own bad behavior, that of others throughout the industry, or events beyond anyone’s control.
So, we need SPOE. Without it, all we have left is bankruptcy and that won’t work for liquidity runs that take the good down with the bad in a systemic crisis. SPOE is our hoped-for last resort so that big banking organizations can be resolved without taxpayer risk. But, after agreeing we need SPOE, how to make it more than a hope? SPOE is premised on a non-operating parent company that issues enough long-term, unsecured debt that all of this can be converted into equity or hair-cut and then used to recapitalize material operating subsidiaries. The tricky bit here is how much long-term debt is enough to make this happen and Mr. Tarullo provides no more light on this than he has in past speeches urging this course of action.
Instead, he adds several new ideas into the mix – ideas that are perhaps meant to be considered in conjunction with the long-term debt idea or adopted in its absence. These new thoughts are first the idea of “internal bail-in” debt that material operating subsidiaries would issue so that the parent company has this in hand to bail them back out again. Either in conjunction with top-tier bail-in debt or new, internal bail-in issuances, the parent company could also be made squeaky clean – that is, Mr. Tarullo says it would be expressly barred from being in any way an operating company and also be subject to short-term debt limits to prevent run-risk at the parent level.
What all of these ideas have in common is that operating subsidiaries need to have contingent capital on hand in the parent to restore them in a jiffy, with top-tier run-risk eliminated because all the parent can issue is capital and long-term debt. What none of them answers is how regulators can tell if the parent company is clean enough and backed by so much long-term debt and equity that nothing ill can befall operating subsidiaries at home and abroad. This might be doable – might be – for a subsidiary bank. Enough is known at least in the U.S. about how to put one into receivership, assuming of course the FDIC can deal with counterparty runs in qualified financial contracts. But, we still know next to nothing about how to judge subsidiary risk in SIFIs when these subs aren’t banks. And, of course, big bank holding companies include lots of operating subs that aren’t banks and many SIFIs aren’t banks at all.
The Financial Stability Board has proposed new resolution protocols for insurance companies and holders of asset management, but these don’t in any way clarify how these resolution regimes are to be incorporated into SPOE when firms in these business lines are under the SPOE regime as planned in the U.S. Indeed, each contemplates stand-alone resolution protocols, some of which might include Mr. Tarullo’s internal bail-in debt and others of which go in very different directions.
There are ways to make all of this work and thus to take SPOE off the drawing board, but none of them has been made public yet, let alone implemented. No wonder the president of the Federal Reserve Bank of Richmond threatened again today simply to restructure big banks because he can’t count on any of their living wills. The industry has many objections to the Tarullo plan for long-term debt issuance and short-term debt limits, but worse may well await them if nothing credible shows itself – and soon.