Why a Big Bank Failure Isn't in the Offing (Yet)

WASHINGTON — When the Dow Jones Industrial Average entered free fall this week before recovering somewhat on Thursday, the rhetoric over a possible big bank failure heated up.

The most obvious target was Bank of America Corp., which saw its stock price plummet amid concerns about its exposure to Europe and significant put-back risk. Despite the bank's claims that it had sufficient capital and liquidity to weather the storm, some analysts began publicly saying its days were numbered.

That, in turn, gave rise to speculation about whether regulators were prepared to take down a large bank, or if the new Dodd-Frank resolution authority was even workable.

With that in mind, we offer the following frequently asked questions to sort out whether a failure is in the offing and how regulators would know when to take out a big bank.

Is Bank of America about to fail?
No. The Charlotte-based banking company is in a weakened state, but it's far from dying. It has a significant amount of capital and — much more importantly — liquidity. In the cases of other large bank failures, including Washington Mutual, liquidity turned out to be the key factor. Facing a bank run, Wamu was rapidly losing its deposit base, forcing regulators to step in.

B of A for right now seems to be having no problem paying its bills, and there are no signs of a bank run. At the end of the second quarter, it held roughly $402 billion in excess liquidity, giving it some room to breathe.

Then why are people talking about it?
Psychology is at least as important as the numbers in stressful times. The name of the game has always been confidence. So long as investors and the public believe Bank of America is not going to fail, it probably won't. The minute the market concludes the bank is dead in the water, however, it will suddenly have a lot more trouble operating in a normal fashion.

Confidence, for better or for worse, is often a reflection of stock price. So when investors and the public see a bank's stock crater, as happened to B of A, they start to ask whether the market has confidence in it. That, in turn, leads to more questions about a firm's health, which can undermine its position further.

How will regulators know when to step in?
This is the $64 billion question, because it relies on a subjective judgment from regulators.

John Carney, a senior CNBC editor, wrote several blog posts (here and here) this week arguing that Dodd-Frank provides little guidance to tell the agencies when to act.

"There is no trigger for when regulators should step in," Carney said. "It's entirely discretionary."

This is true, to a point. The Dodd-Frank law, which created new resolution authority for large systemic companies, does not have a hard and fast mechanism that would require regulators to act. Indeed, the process is somewhat labyrinthine, as I will explain shortly.

But the law does offer some clues for when regulators should step in, saying the agencies should act if a systemically important firm is "in default or in danger of default." What this essentially means is this: the company would have to be close to or in the process of filing bankruptcy. Moreover, for regulators to step in, they would have to conclude that it would be less disruptive for the market to seize the institution than allowing it to enter bankruptcy.