As the Federal Deposit Insurance Corp’s resolution powers for large banking companies have become a leading target in the debate over rolling back the Dodd-Frank Act, supporters are proposing reforms to make those powers more palatable to Republicans who oppose them.
In a panel Tuesday at the Brookings Institution, several prominent defenders of orderly liquidation authority argued that its repeal could pose great risks to the financial system.
“Lehman’s failure was the critical moment in the acceleration of the global financial crisis,” said former Federal Reserve Chairman Ben Bernanke. “What we lacked in 2008 was the legal structure to do things in an orderly systematic and transparent way.”
“Now,” added Bernanke, “for no reason I can see there is this desire to eliminate this critical backstop authority.”
Dodd-Frank’s OLA provision would be repealed under House Financial Services Committee Chairman Jeb Hensarling's Financial Choice Act, which is to be voted on by the full House on Thursday. Conservatives contend that the authority amounts to a bailout because it would allow the FDIC to borrow money from the Treasury to fund the resolution of a failing systemically important financial institution.
“It is a way for the government to craft a bailout without telling people it is a bailout,” Hester Peirce, a senior research fellow at the Mercatus Center, said during the panel.
She argued that if government were to step in, a decision should be made legislatively. “Congress in that moment can make a determination,” Peirce said. “That was what happened with Tarp,” the Troubled Asset Relief Program.
Bank lobbyist H. Rodgin Cohen, the senior chairman at Sullivan & Cromwell, argued that orderly liquidation authority should be kept in place, but he acknowledged that it could be made more fiscally conservative.
First, he proposed to reduce the amount of time financial institutions would have to pay back the government for a potential liquidity infusion. (If the FDIC does need to borrow money from Treasury to resolve the firm, it would ultimately be reimbursed with the assets of the failed firm or through assessments on large financial institutions.) That window could be reduced from five years to about six months or a year, Cohen said.
In addition, Cohen said, the maximum amount that the FDIC could borrow to unwind a systemically important financial institution could also be reduced, from about 90% of the “fair value” of the firm after its failure to perhaps 70%.
OLA, which is part of Title II of Dodd-Frank, is “a logical extension” of other special resolution regimes for particular types of financial institutions, such as broker-dealers, and of a number of pre-existing special authorities government agencies have to step in if a bank fails, said Cohen.
Banks "do run into particular liquidity problems," he said. "We are now 104 years since the government decided that we need a lender of last resort."
But these changes are not likely to satisfy conservatives who are staunchly opposed to orderly liquidation authority, which they say could create incentives for banks to act recklessly.
“It does create a laziness,” Peirce said. The “government can swoop in through OLA, dump a lot of money in the firm and solve a problem.”
The process is not transparent enough, she added. “It is a way for the government to craft a bailout without telling people it is a bailout.”
Peirce argued that reforming the FDIC's powers at the margins would not change the basic fact that it could be extremely costly for taxpayers in the short term.
Even borrowing up to 70% of a company’s fair market assets, “if you’re talking about JP Morgan that’s a huge dollar figure,” she said. “The idea that during a financial crisis you would be able to get firms to pay that amount back in six months or even five years.”
Bernanke retorted that OLA comes with “a whole lot of rules,” laying out the sequencing of events and the prioritization of creditors to pay back.
“There’s a lot of effort put into the law to address the moral hazard problem,” he said. “We have fire codes … but in the end, if the town is burning you have to send the firetruck.”
David Skeel, a professor of corporate law at the University of Pennsylvania, said that orderly liquidation authority had already progressed as the FDIC developed a working model for its resolution strategy.
Under its single-point-of-entry plan, the FDIC would perform the wind-down of the firm at the holding company level. Most short-term debt and assets would be placed in a bridge company, allowing subsidiaries to keep running while the company is liquidated.
“The argument that Title II is entrenching a bailout made some sense initially,” said Skeel. “But then single-point-of-entry came along.”
Bernanke also argued that regulators were better prepared than bankruptcy courts to solve the failure of a systemically important financial institution, given their experience.
“The antagonism towards Title II is puzzling to me, because the FDIC has been resolving banks” for decades, he said. For a “judge, even if their mandate includes attention to financial stability, they won’t have information about what’s happening in the money market funds, for instance.”
"The bankruptcy system has no need for speed," he said.
Orderly liquidation authority, Bernanke added, would also ensure that foreign regulators have a seat at the table during the failure process. If they felt they have no control, they would likely freeze the financial institution’s assets abroad, he argued.
“What our partners would just do is just ring-fence all the deposits or assets of our firms in other countries,” he said.
In order to prevent this from happening, Cohen called for a four-party treaty on the resolution of large financial institutions.
Under its terms, the U.S., U.K., European Union and Japan “would recognize the resolution regime of the home country of the banking institution,” he said.
Bernanke also criticized Hensarling’s Dodd-Frank rollback plan more broadly. The bill would allow banks to opt out of certain requirements if they agreed to hold a 10% leverage ratio. But raising capital leverage ratios on banks is not sufficient to protect the markets, Bernanke said.
"While I agree with the principle that more capital should make banks safer, it needs other indicators of capital," he said.
Without this, banks “would have a strong incentive to change the mix of assets they hold [and] they would hold riskier assets.”