The Inside Story of How the Clearing House Proved Dodd-Frank Works

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Although the industry's track record with Dodd-Frank implementation is hardly noteworthy, its war game to test regulators' new powers to seize and dismantle a megabank is not only fascinating, it's exemplary.

The Clearing House Association, a trade group made up of the 18 largest banks, spent 10 months and $2 million to plan a simulation of a large bank failure, a bold and massive undertaking.

"Had this not gone well, it would have complicated the debate immensely," says Paul Saltzman, the group's president.

Barbara A. Rehm

That may be the understatement of 2012.

Whether Dodd-Frank's Title II ends the notion of "too big to fail" will affect how rules that bring the reform law to life are written. If regulators do not trust Orderly Liquidation Authority — the process regulators will use to resolve a failing megabank — will work, then rules governing capital to corporate governance and everything in between will need to be a whole lot tougher.

"Demonstrating to policymakers that there is an effective resolution framework is a critical part of the regulatory dialogue now," Saltzman says. "It will inform all of the macroprudential rules and regulations that are being put in place to prevent a future failure."

Industry critics will never be convinced; they view The Clearing House's simulation as self-serving.

But it's hard to deny the industry some credit for trying to test how the government might take down a large bank without causing a full-blown crisis followed by an expensive bailout.

Was the simulation perfect? No, but that's the wrong yardstick. It's enough to say the simulation was constructive. And it provides perhaps the single most visible example of the industry proactively participating in Dodd-Frank's implementation, which is so much more effective than whining, or worse, undermining from the sidelines.

The simulation took place in Hurricane Sandy's wake in early November at the Doral Arrowwood in Rye Brook, N.Y. The 180 participants, including 150 bankers from 23 institutions, split into 11 teams to play a variety of roles. The simulation focused on the failure of a $1.9 trillion-asset U.S.-based bank, but included two others: another U.S.-based bank with $850 billion of assets and a U.K.-based bank with $2.5 trillion of assets.

The eight other teams covered the roles played by the Federal Deposit Insurance Corp., other U.S. regulators, U.K. regulators, Congress, buy-side investors, market utilities, the media and finally a "command central" that oversaw the simulation.

Each of the 11 groups had a distinct briefing book, with a list of tasks and objectives. Each had its own room, equipped with a TV that provided a media feed, which included a variety of rumors designed to inject some chaos and make the simulation more real. "Reporters" on the media team were instructed to seek out information and participants were allowed to call the media to plant stories and try to influence events.

The Clearing House hired Ernst & Young as the project manager as well as Promontory Financial and a who's who of law firms including Davis Polk and Cleary Gottlieb.

The simulation was divided into four phases and assumed that Dodd-Frank had already been implemented. In other words, any limits proposed but not yet adopted by federal regulators were assumed to apply.

The "crisis" began with the news that Bank A had suffered a $6 billion loss in its U.K. broker-dealer on a Friday morning. That afternoon the company's U.S. commercial bank was hit with a $50 billion loss. Runs followed; confidence faded and Bank A's holding company faced a big debt repayment that it could not meet. It became clear the government had to step in or risk systemic contagion.

Dodd-Frank bars regulators from bailing out any individual bank so Bank A could not simply turn to the Federal Reserve Board for financial help. Under Dodd-Frank, the FDIC must decide that a bank's failure could create a crisis that would threaten the entire financial system and then convince other policymakers to go along.

FDIC Chairman Martin Gruenberg has said the agency's preferred approach to these types of resolutions will be a "single point of entry" where the holding company is seized and operating subsidiaries continue to function, so that's what the Clearing House tested.

In the simulation, the FDIC wiped out shareholders, fired the CEO (played by Greg Baer of JPMorgan Chase) and converted holding company creditors to owners of the new bridge bank.

To cover the bank's losses, the FDIC arranged an $80 billion line of credit that was funded by institutional investors and guaranteed by the Orderly Liquidation Fund, which was mandated in Dodd-Frank. The law requires other large banks to repay this money. (The people playing FDIC officials, led by Mike Krimminger of Cleary Gottlieb, asked for $200 billion, but the folks playing Treasury Department officials, led by Michael Helfer of Citigroup, only approved $80 billion; in the end only $40 billion was tapped.)

There's more, but that's the basic setup.

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Comments (1)
For all its problems and shortcomings, game simulation is crucial to understanding how humans will react (or could react) in any given set of circumstances. This has been true in the military (war games) and there is every reason to think that it would provide benefits to the regulators in the financial arena. I would humbly suggest that the entire exercise be monitored live by the regulators or video-taped next time (assuming that wasn't done this time), with the full understanding that the participants are simply acting their parts.

Really good reporting. Thank you.
Posted by GMahler | Thursday, December 20 2012 at 10:32AM ET
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