WASHINGTON — The Federal Deposit Insurance Corp. still has a long way to go before it can be ready for the next financial crisis.
That was an important finding of a report by Federal Financial Analytics this week on the status of the FDIC's facility to resolve financially troubled megacompanies. Though the private firm's report praised the progress made in developing the wind-down system, it detailed issues that need attention — from the treatment of certain derivatives contracts to steps to ensure the resolution process resembles bankruptcy.
"There are several outstanding uncertainties that will need to be resolved before" the orderly liquidation authority "is complete and market participants can anticipate its impact should systemic risk force its use instead of the Bankruptcy Code," said the report, which was commissioned by the Securities Industry and Financial Markets Association.
The resolution regime — included in the Dodd-Frank Act to allow special wind-downs when the government deemed a bankruptcy would hurt the system — will always be hard to envision until used, and the market will likely keeping demanding clarity from the FDIC.
Yet the FDIC "has largely implemented" the system "in key respects," through rules regarding creditor claims, compensation clawbacks and other matters, the report said. FDIC Chairman Martin Gruenberg's speech in May on the agency's plans to utilize bridge entities during resolutions was also instructive, the report said.
But the report recommended further steps that need to be taken through formal policy statements. They include outlining the structure of bridge entities; addressing the challenges of cross-border resolutions; requiring recordkeeping for derivatives and other qualified financial contracts; and detailing the treatment of broker-dealers and futures commission merchants in the resolution regime. The report also discussed a test the FDIC must create to ensure creditor relief in a resolution equals that in a bankruptcy, and ongoing reviews of firms' so-called living wills.
Some of the remaining steps carry more weight than others, Federal Financial Analytics managing partner Karen Shaw Petrou said in an interview.
For example, she singled out the "bankruptcy-equivalence test" as a difficult task facing the agency. Essentially, on a case-by-case basis, Petrou said, the FDIC would need to be able to prove that creditors of a firm wound down in the regime would not have received more in a traditional reorganization.
But any disputes over what an individual creditor receives will not threaten the effectiveness of the overall regime, said Petrou, who thinks the resolution regime gets policymakers closer to eliminating the too-big-to-fail problem.
"That's an empirical question that is very hard to know because there have been very few Chapter 11 bankruptcies of giant financial firms," she said. "Ultimately what I think is going to happen there is the FDIC will make a decision, and creditors won't like it, and then some of the creditors will sue. That will lead to litigation risk for the FDIC, but not too-big-to-fail risk."
The FDIC must also set standards for how firms track their QFCs — which encompass derivatives and other types of contracts — because the FDIC would need to approach its handling of such commitments carefully in a resolution to curb systemic effects.
Meanwhile, Petrou said, the FDIC and Federal Reserve Board's evaluation of living wills — firm-drafted resolution plans meant to help prepare the FDIC and the company itself for a bankruptcy-like reshuffling — is crucial. Under Dodd-Frank, the plans must show that firms are structured in a way that a company can be unwound, and if they are not, the regulators can force them to simplify themselves. But the regulators have to be brave enough to use that authority for it to work, Petrou said.
"The way you make the risk" of taxpayer support "diminished or disappear is by using the living wills to ensure that [systemically important financial institutions] do, as the law requires, plan for Chapter 11. … And if the regulators see a problem they have the guts to force an entity to divest or otherwise restructure," she said. "To date, the ability of the bank regulators … to go toe-to-toe with a SIFI and tell it to do something the SIFI doesn't want to do is uncertain."
Other remaining tasks may be less complicated, she said. For example, while several observers say the biggest obstacle to effective resolutions is dealing with a failed firm operating in multiple countries, Petrou said that issue may be simpler than onlookers think.
That is because the vast majority of the foreign operations of U.S. firms subject to the regime are based in the United Kingdom, and "the U.K. is much farther along in its resolution planning than the U.S. and a lot of work is already being done."
"We're in pretty good shape on that one. It's not done, but it's much more practically complete than it might look," she said.
Overall, Petrou commended the FDIC for moving swiftly in completing rules related to the regime — compared with much slower progress by other agencies implementing other provisions — and was cautiously optimistic that the facility is a better defense against the type of chaos that choked the markets in 2008.
"They've done a unique job in enacting Dodd-Frank," she said of the FDIC. "Everything else the law mandated is incomplete or not even yet proposed.
"On its face, as enacted and how it's being implemented, is it a credible process that gives the FDIC all of the tools it needs to end too big to fail? To me, the answer there is a guarded 'yes'."