The Fed’s Deeply Flawed Strategy for Resolving Failed Megabanks

Arthur E. Wilmarth, Jr. is a Professor of Law at the George Washington University Law School. This post is based on a recent article by Professor Wilmarth.

In my article SPOE + TLAC = More Bailouts for Wall Street, which was recently published in the Banking & Financial Services Policy Report, I discuss a new strategy that the Federal Reserve Board (Fed) has proposed for dealing with failures of global systemically important banks (G-SIBs). My article points out a number of serious shortcomings in the Fed’s proposal and argues that significant reforms must be made before the plan is implemented.

A primary goal of the Dodd-Frank Act is to end “too big to fail” (TBTF) bailouts for systemically important financial institutions (SIFIs) and their creditors. Title II of Dodd-Frank establishes the Orderly Liquidation Authority (OLA), which empowers the Secretary of the Treasury to appoint the Federal Deposit Insurance Corporation (FDIC) as receiver for failed SIFIs. Title II requires the FDIC to liquidate failed SIFIs and to impose any resulting losses on their shareholders and creditors. Title II establishes a liquidation-only mandate because Congress did not want a failed megabank to emerge from an OLA receivership as a “rehabilitated” SIFI.

The FDIC recognized Title II’s liquidation-only mandate in its early rulemakings under Dodd-Frank. However, megabanks quickly realized that a liquidation-only approach for resolving failed SIFIs would pose a major threat to their TBTF subsidy and would create a clear risk of imposing losses on their Wall Street creditors, including holders of commercial paper and securities repurchase agreements (repos). Accordingly, in 2011 Wall Street interests proposed a very different approach for resolving failed SIFIs. This new approach, called “recapitalization-within-resolution,” created a roadmap for resolving failed megabanks by using Chapter 11-style reorganizations instead of liquidations. Wall Street’s reorganization plan helped to provide the conceptual foundation for the “single point of entry” (SPOE) resolution strategy.

The SPOE strategy would place only the parent holding company of a failed megabank into an OLA receivership and would impose losses only on the holding company’s shareholders and debtholders. Under SPOE, the operating subsidiaries of a failed SIFI (including banks, securities broker-dealers, swap dealers, and insurance companies) would remain in business, and all of the creditors of those subsidiaries (including Wall Street creditors) would be fully protected. Wall Street enthusiastically supports the SPOE concept, but the FDIC has not yet formally endorsed SPOE as its preferred strategy for resolving failed SIFIs under Title II of Dodd-Frank.

The Fed recently proposed a new “total loss-absorbing capacity” (TLAC) requirement for G-SIBs. The proposed TLAC requirement would apply to eight U.S. megabanks as well as U.S. intermediate holding companies owned by foreign G-SIBs. The Fed’s proposal would require the parent holding company of each G-SIB to maintain a minimum level of Tier 1 shareholders’ equity and TLAC debt. If the parent holding company is placed in an OLA receivership, an SPOE resolution would follow and the parent company’s equity and TLAC debt would be written off to help recapitalize the G-SIB’s operating subsidiaries. The Fed’s TLAC proposal is expressly designed to establish SPOE as the preferred strategy for resolving failed U.S. megabanks.

Most TLAC debtholders would probably be retail investors in mutual funds and pension funds, because federal regulators would strongly discourage financial institutions from purchasing TLAC debt. In addition, if a failed G-SIB’s subsidiaries could not be recapitalized by writing off the holding company’s equity and TLAC debt, the FDIC as receiver would fill the remaining gap by obtaining a taxpayer-financed bridge loan from the Treasury Department through the Orderly Liquidation Fund (OLF). During congressional deliberations over Dodd-Frank, Wall Street successfully blocked proposals that would have required SIFIs to pay risk-based premiums to prefund the OLF. As a result, the OLF has a zero balance, and the FDIC must take out Treasury-approved loans from the OLF to cover any net losses from resolving failed SIFIs. Accordingly, SPOE and TLAC would impose the costs of resolving failed megabanks on ordinary citizens, either as investors or taxpayers, while giving 100% protection to Wall Street creditors.

It is highly doubtful whether the Fed’s proposed SPOE-TLAC strategy would be successful in resolving failed G-SIBs. It is far from clear whether the parent holding company of a failed G-SIB can be placed in an OLA resolution without triggering contagious runs by the creditors of its subsidiaries. There are also strong reasons to question whether foreign regulators with jurisdiction over a failed G-SIB’s subsidiaries would cooperate if the FDIC commenced an SPOE resolution procedure for the parent holding company. An SPOE resolution would be undermined if foreign officials decided to “ring fence” subsidiaries or assets located within their jurisdictions.

Moreover, any attempt to impose losses on a failed G-SIB’s TLAC debtholders would probably trigger widespread panic among investors who hold bail-in debt issued by other G-SIBs that are believed to be vulnerable. In February 2016, after regulators imposed losses on bondholders in failed Italian and Portuguese banks, a major selloff occurred in the market for contingent convertible bonds (CoCos) issued by European banks. That selloff has created substantial doubts about the ability of regulators to bail in TLAC debt without disrupting financial markets.

The most fundamental flaw in the Fed’s SPOE-TLAC proposal is that it would entrench our perverse system for regulating SIFIs. Our current regulatory system enables megabanks, their executives, and Wall Street creditors to reap massive benefits from the TBTF subsidy while imposing the costs of that subsidy on ordinary citizens. We must reject this intolerable situation, and we must shrink the TBTF subsidy by forcing SIFIs, their insiders, and Wall Street creditors to internalize the costs of the enormous risks created by megabanks.

My article proposes four reforms that would help to reduce the TBTF subsidy. First, regulators should require G-SIBs to satisfy all or most of their TLAC requirements by issuing Tier 1 equity capital. Tier 1 equity capital provides a far superior buffer for absorbing losses, compared with bail-in debt. The Fed’s proposal is therefore plainly wrong in arguing that G-SIBs should meet almost half of their TLAC mandates by issuing bail-in debt.

Second, if any bail-in debt is to be credited toward satisfaction of the TLAC standard, the Fed should require all newly-issued TLAC debt to be marketed and sold as subordinated debt that is junior to the claims of all other G-SIB creditors. Requiring TLAC debt to be explicitly designated as subordinated debt would minimize the risk of misleading investors and would require G-SIBs to pay higher interest rates that reflect the extraordinary hazards of bail-in debt. If G-SIBs decide to avoid paying those interest rates by issuing Tier 1 equity capital to meet their TLAC mandates, that would be a highly desirable result.

Third, SIFIs (including G-SIBs) should pay risk-adjusted premiums to provide at least $300 billion of prefunding for the OLF. The required premiums should include fees for uninsured deposits and short-term shadow banking liabilities, such as commercial paper and repos. A prefunded OLF would reduce the likelihood of imposing resolution costs on taxpayers when SIFIs fail.

Finally, SIFIs (including G-SIBs) should pay at least half of their total compensation to senior executives and other key insiders (including risk managers and traders) in the form of bail-in debt. Insiders should not be allowed to hedge, sell, or convert their bail-in debt into stock until several years after their employment ends. Bail-in debt would be a viable form of compensation for key insiders because (unlike outside investors) insiders could be legally barred from selling or hedging their holdings of bail-in debt. Bail-in debt would align the interests of key insiders with other long-term creditors (including the FDIC and taxpayers), because insiders would suffer significant losses if their SIFI fails and their bail-in debt is converted into equity or written off.

The four reforms described in my article would not eliminate the TBTF subsidy, but they would reduce that subsidy by forcing SIFIs and their insiders to internalize at least some of the massive risks that megabanks impose on society. Those reforms would also give SIFIs much-needed incentives to reduce their risk-taking, size, and complexity, and to follow business strategies that are prudent and sustainable over the longer term.

The full article is available for download here.

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