WASHINGTON If the Federal Deposit Insurance Corp.'s big-bank cleanup plan were a video game, the agency would be past the opening levels but still a good ways from defeating the final villain.
That is the main takeaway from early comment letters on the agency's blueprint for resolving systemically important firms. Bankers, industry representatives and other observers largely praise the FDIC's favored resolution method "single point of entry" but say more details are needed on how it would work amid vast challenges to unwinding behemoths smoothly.
The plan the FDIC's answer to implementing the Dodd-Frank Act's "orderly liquidation authority" would force parents to close with remaining debt and equity going to support subsidiaries in an FDIC-managed bridge company. But questions remain about whether that gives subsidiaries an unfair advantage, what a new company would look like post-resolution and how the FDIC would work with other U.S. and foreign regulators, among others.
"By seeking to resolve a firm at the holding company level the SPOE approach provides a single and less complex plan that the FDIC can implement relatively quickly, even for different types of large and complex financial institutions," former FDIC Chairman Sheila Bair wrote in a Feb. 18 letter to the agency on behalf of the Systemic Risk Council, which she now chairs. "Unfortunately, the SPOE approach also carries with it a number of potential risks that must be addressed for OLA to achieve the goals for which it was intended."
The FDIC released a document Dec. 10 detailing its plans for using the "single point" strategy after agency officials had publicly endorsed the approach for well over a year.
If the government opts to use the FDIC's facility to resolve a failed firm, rather than processing it through bankruptcy, the agency's strategy calls for locking the holding company's doors, haircutting or wiping out its creditors and shareholders to fund subsidiary operations, restructuring the organization to make it less of a systemic threat and converting creditor claims into equity in the new company or companies that would emerge.
Big banks, which have opposed other policy ideas aimed at eliminating the "too big to fail" problem, are hailing the FDIC roadmap.
The "strategy ensures that shareholders and creditors of the parent would absorb losses, as they should; management responsible for the failed condition of the financial group would be removed, as they should be; taxpayers would bear no losses, as they should not; critical operating businesses of the organization would stay open to serve the broader economy, as they must; and the failure would not destabilize the U.S. financial system," according to a joint Feb. 18 letter submitted by the Clearing House Association, Securities Industry and Financial Markets Association, American Bankers Association, Financial Services Roundtable and the Global Financial Markets Association.
But, generally speaking, the more than 20 commenters who submitted letters by an original Feb. 18 deadline said while the FDIC deserves credit for its progress to date, many issues need attention before "single point of entry" can be called operational. (The agency announced Feb. 18 that it was extending the deadline to March 20; some parties that already submitted letters indicated they would be making supplemental comments.)
"The SPOE proposal is a good start, although it could benefit from much greater specificity," Stephen J. Lubben, a professor at the Seton Hall University School of Law, wrote on Feb. 7.
Among concerns of some skeptics is that under the plan investors will expect a guarantee at the subsidiary level, leading to moral hazard.
"By applying losses at the holding company level and leaving subsidiaries open and functioning the proposed SPOE approach risks a resolution scenario where individual holding companies lack sufficient loss absorption capacity and inflict costs on other financial institutions, or worse, taxpayers [and] the creation of gaming/moral hazard opportunities at the operating subsidiary level," wrote Bair, who added the FDIC has acknowledged such risks.
Observers also warned that without proper controls, a firm could choose to concentrate risk underneath the parent in entities expected to survive in a resolution.
"SPOE needs a barrier so that taxpayer bail-out risk isn't downstreamed from big BHCs resolved through SPOE to subsidiaries into which investors park their risk in anticipation that holding-company resources combined with federal support will protect them," wrote Karen Shaw Petrou, managing partner at Federal Financial Analytics.
FDIC officials have said the agency would consider liquidating truly defunct subsidiaries, but some commenters said that wasn't enough.
Lubben suggested the FDIC should expressly say it only plans to keep "solvent" subsidiaries operating, or at least lay out how it would deal with an insolvent subsidiary. He noted, for example, that American International Group, which received a huge bailout from the government in 2008, got into trouble not because of its parent but due to credit default swap losses at its subsidiary AIG Financial Products.
"How precisely would" single point of entry "have worked in a case like AIG?" he said. "Would AIG FP really keep performing on its CDS contracts?"
Others countered that concern about undue support for subsidiaries is misguided, highlighting a proposal due soon from the Federal Reserve Board that is expected to force companies to keep sufficient debt and equity levels at the holding company.
"SPOE dispels any remaining misperception of a funding advantage due to government support by establishing clear mechanisms for ensuring that losses will be borne by a SIFI's shareholders and unsecured creditors and requiring SIFIs to maintain higher minimum levels of loss absorbing instruments compared to their smaller competitors," Paul R. Ackerman, executive vice president and treasurer for Wells Fargo, wrote in a Feb. 18 letter.
Some commenters also addressed questions about the final stages of the resolution process, highlighting risks of any new private company emerging from the FDIC restructuring looking like the old one.
"While the FDIC SPOE proposal notes that one or more new companies will emerge from the SPOE process, state supervisors firmly believe that the end result should be multiple private sector firms that are less complex, less interconnected, and do not perpetuate the prior firm's threat to financial stability," wrote John Ryan, chief executive of the Conference of State Bank Supervisors, in a Feb. 18 letter.
Bair raised similar concerns. She said it would be difficult for the FDIC to make restructured firms no longer a systemic threat, meaning banks should focus on simplifying their structures before a resolution is ever needed. Under Dodd-Frank, Title I requires large firms to draft internal resolution plans as a way to become less complex.
"Though the FDIC expects that any systemic firm emerging from a resolution will be broken into non-systemic pieces resolvable in bankruptcy, the morass of interconnected legal structures which typify U.S. SIFIs cast doubt on whether the FDIC could realistically accomplish this objective," she wrote.
"Rather, without further progress under Title I to require U.S. SIFIs to simplify and rationalize their legal structures, the most likely outcome of the SPOE approach will be to replace one systemic firm with another. While this new firm will be 'different' in many respects from the one it replaced, it could still have the same name, many of the same employees, and pose the same external risks to the system."
Meanwhile, numerous commenters said there is still uncertainty about how the FDIC would work with foreign regulators regarding a failed firm's overseas operations.
The FDIC has developed cross-border agreements with foreign jurisdictions and "single point of entry" is meant to reduce the chance of countries "ring-fencing" to protect citizens, since subsidiaries are expected to resume operations without a hiccup. But some observers noted the agreements are non-binding and foreign countries may look out for their own national interests in a crisis.
The FDIC's "notice leaves open a number of cross-border issues that must be addressed in greater detail by the FDIC," wrote members of the Committee on Capital Markets Regulation in a Feb. 18 letter. "In particular, the FDIC will need to give credible assurances to foreign authorities that material subsidiaries operating outside the United States will be given fair treatment regarding capital injections. In addition, the FDIC must ensure that the resolution strategy will preserve the critical functions operating in foreign jurisdictions."