What It Takes for the FDIC SPOE Resolution Proposal to Work

The following post comes to us from Karen Petrou, co-founder and managing partner of Federal Financial Analytics, Inc., and is based on a letter and a FedFin white paper submitted to the FDIC by Ms. Petrou; the full texts are available here.

In a comment letter and supporting paper to the FDIC on its single-point-of-entry (SPOE) resolution concept release, Karen Shaw Petrou, managing partner of Federal Financial Analytics, argues that SPOE is conceptually sound and statutorily robust. However, progress to date on orderly liquidation has been so cautious as to cloud the credibility of assertions that the largest U.S. financial institutions, especially the biggest banks, are no longer too big to fail (“TBTF”). Crafting a new resolution regime is of course a complex undertaking that benefits from as much consensus as possible. However, if definitive action is not quickly taken on a policy construct for single-point-of-entry resolutions resolving high-level questions about its practicality and functionality under stress, markets will revert to TBTF expectations that renew market distortions, place undue competitive pressure on small firms, and stoke systemic risk. Even more dangerous, the FDIC may not be ready when systemic risk strikes again.

Questions addressed in detail in the paper and Ms. Petrou’s answers to them are summarized below:

Q. Does SPOE work for complex BHCs? Can fast-flying derivatives be handled? Which subsidiaries will be saved?

A. SPOE is conceptually sound within the U.S. for the largest BHCs, with regard to credit, liquidity, and operational risk at individual firms and across the industry. However, this is true only if the FRB’s rules require a sufficient level of shareholder equity and long-term, unsecured debt ahead of the FDIC and, then, the market can absorb these obligations without pricing or other market distortions that exacerbate “shadow” risk. Bankruptcy resolution—always to be preferred over SPOE—is best achieved through statutory change in the U.S. to handle complex financial instruments. SPOE also cannot be operationalized without strong living wills that permit the FDIC quickly to identify which subsidiaries will be supported and which will fail in concert with the BHC or systemically-important financial institution (“SIFI”).

Q. Can big-bank resolutions be accomplished across national borders?

A. Recent FDIC efforts to craft cross-border resolution agreements are admirable, but unlikely to prove effective in a crisis. There is work under way to address this for banks, but cross-border resolution without government intervention is still at best uncertain for banks and wholly unaddressed for non-banks. A critical outstanding policy choice is between the benefits of cross-border branching for ongoing operations and the need instead for ex ante subsidiarization to ensure orderly cross-border bank resolutions.

Q. Can SPOE prevent downstreaming TBTF protection to subsidiary banks in the largest BHCs, just making a new class of TBTF banks?

A. SPOE needs a barrier so that taxpayer bail-out risk isn’t downstreamed from big BHCs resolved through SPOE to subsidiaries into which investors park their risk in anticipation that holding-company resources combined with federal support will protect them.

Q. Are big BHCs the only systemic companies? If not, does SPOE handle other sources of systemic risk and ensure that TBTF doesn’t just shift from banks to non-banks in the next financial crisis?

A. SPOE so far is bank-centric and thus not useful for non-bank SIFIs. As a result, it does not address non-bank risk nor impose on large non-bank financial institutions the same costs contemplated for big banks. This will simultaneously reinforce TBTF for these non-bank SIFIs and create strong regulatory drivers for markets to favor non-banks over BHCs. A potential perverse effect of this bank-centric approach is a downward spiral in which BHCs must issue more and more debt to protect subsidiaries while investors demand ever higher prices for debt due to diminished BHC profitability because more and more high-return activities go to non-bank competitors.

Q. Do financial-market utilities like central counterparties pose systemic risk?

A. A systemic-resolution protocol is urgently needed for central counterparties and other financial-market utilities granted critical systemic roles under Dodd-Frank and new global rules.

The full letter and paper may be found here.

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