The success or failure of the government's efforts to enable resolutions of colossal firms could determine whether banks face a repeat of the fallout that ensued after Lehman Brothers' collapse.
Partner Insights

Four Reasons You Should Care about Big Bank Wind-Down Plans

Print
Email
Reprints
Comment (1)
Twitter
LinkedIn
Facebook
Google+

WASHINGTON — The Dodd-Frank Act's new resolution process applies to only a handful of the roughly 6,700 U.S. banks, but its success or failure is critical to institutions of all sizes.

Regulators are still struggling to implement the complex process, including forcing banks to write "living wills" that detail how they can be dismantled in a crisis and building an effective system of their own capable of resolving them.

Their efforts could ultimately determine whether the era of "too big to fail" banks is over, yet much of the industry's focus has been drawn elsewhere to more high-profile debates over the Volcker Rule, new mortgage restrictions and other issues.

Here are important reasons to stay focused on the wind-down issue:

All banks have a lot riding on the outcome
In their purest forms, the living wills and new Federal Deposit Insurance Corp. system were created to stop a large firm failure from having the systemic impact that nearly brought the financial system to its knees.

During the crisis, policymakers faced two bad choices. One was to allow the bankruptcy of one or more consolidated financial firm. But Lehman Brothers' bankruptcy heightened fears about system stability, leading to deposit outflows and a more severe credit crunch. The spreading crisis was enough to push some already-troubled banks over the edge.

The government began providing massive assistance, including Federal Reserve liquidity, capital infusions and FDIC support for transaction deposits and banks' senior unsecured debt. Those benefits undoubtedly helped banks navigate the crisis. But they also led to regulatory intervention and public backlash.

If the resolution-related provisions of Dodd-Frank work as advertised — and it still is an 'if' — one effect of the reforms is they could limit or prevent ripple effects on bystander banks. The resolution plans which must be submitted by all banks with more than $50 billion of assets are meant to ensure big banks are conducive to a traditional bankruptcy without systemic effects. If a plan is subpar, regulators can require changes at institutions to make their balance sheets easier to unwind in bankruptcy. If the government still does not trust the bankruptcy process, the FDIC can seize the institution and manage the clean-up to minimize systemic disruption.

But if the government's efforts fail, other banks could get caught up in the storm of a big failure once again.

Regulatory efforts could curb a key competitive advantage held by the largest banks
A common complaint about "too big to fail" is that global firms enjoy advantages over midsize and community banks due to the market's belief that the government will save a complex company rather than let its failure damage the system.

If the failure of a colossal firm someday became more plausible as a result of the Dodd-Frank reforms, the competitive gap between big and small institutions could narrow at least somewhat. It is still too early to say whether the living wills process will make firms more "resolvable", and the FDIC's new system will not truly be tested until the agency faces its first big cleanup. But if rating agencies, creditors, investors and depositors start to believe that no firm has a guarantee, it could have a positive effect on smaller banks.

The success or failure of either policy could help determine the fate of other proposals to stop "too big to fail."
For all of its sweeping reforms, Dodd-Frank did not stop talk about other ideas to curb risks from systemically important banks. Lawmakers, former bankers and regulators, and others have called for more direct steps to "break up" big banks. A recent bill proposed by Sens. David Vitter, R-La., and Sherrod Brown, D-Ohio, would hike megabank capital requirements and limit the government safety net to traditional banking. A similar idea touted by FDIC Vice Chairman Thomas Hoenig would restrict FDIC-insured banks from using the safety net to engage in nonbank financial activities.

None of these recent proposals, which could also have effects on smaller banks, are likely to be considered anytime soon. Whether or not the living will process and the FDIC's resolution system prove the end of "too big to fail" could help decide if policymakers ever look more closely at additional reforms.

Living wills could be more than just blueprints
Each bank subject to living will requirements must submit a plan annually to the Federal Reserve Board and FDIC, including a detailed cataloguing of its business lines and a narrative about how it would be unwound in bankruptcy.

While the intent is to help the FDIC with preparations and get firms thinking about their structure, the process is also meant to be more than academic. Under Dodd-Frank, regulators can take remedial action against firms with plans deemed not credible. That essentially means officials can judge if a particular firm's bankruptcy would or would not cause systemic fallout, and then force changes at the company to position it for a more orderly bankruptcy. It is unclear how aggressively regulators plan to use this authority, but it could lead to structural changes at big firms long before a failure ever occurs.

JOIN THE DISCUSSION

(1) Comment

SEE MORE IN

RELATED TAGS

'I Want a Tom O'Brien Action Figure Doll': Comments of the Week

American Banker readers share their views on the most pressing banking topics of the week. Comments are excerpted from reader response sections of AmericanBanker.com articles and from our social media platforms.

(Image: Bloomberg News)

Comments (1)
Buttresing regulatory provisions to avoid bailout is not new. The concept has failed over several different crisis cycles. The idea that we can now get it right through Dodd Frank is another self delusion. Let banks operate and fail under free market principles no matter how ugly their demise may be. Failure is always caused by poor decisions. How is this re established? Only by limiting the size of banks and investment banks. Perhaps to 3% and 2% of GDP respectively as suggested by MIT scholars in 13 Bankers.
Posted by TxTim | Monday, June 23 2014 at 9:54AM ET
Add Your Comments:
Not Registered?
You must be registered to post a comment. Click here to register.
Already registered? Log in here
Please note you must now log in with your email address and password.
Already a subscriber? Log in here
Please note you must now log in with your email address and password.