WASHINGTON — Senate Banking Committee Chairman Chris Dodd's regulatory reform bill is generally winning praise for provisions giving the government more power to smoothly unwind a large, systemically important firm, but is also raising a host of practical concerns observers say could undermine its effectiveness.

Chief among them are whether the Federal Deposit Insurance Corp. could handle such a failure, if a proposed judicial review would have any impact and if a $50 billion resolution fund would simply spur more bailouts.

Those issues and others are likely to surface this week as Senate Banking begins to debate the Dodd bill today.

"When you read it, it looks like it makes sense, but when you think about how it will work in practice you have to kind of dial your brain back to the Lehman bankruptcy," said Joseph Mason, Louisiana Bankers Association Professor of Finance at Louisiana State University. "This is not clean at all. It is a very messy construct and more thought needs to be devoted to this."

Still, Mason, who has advised Republicans on the provisions, said the latest draft was the most thought-out version of resolution language he's seen so far.

"It is an improvement from the previous bill," he said. "They've gotten off of how to prop firms up and moved to how to shut them down."

The resolution provisions resulted from extensive negotiations between Sens. Mark Warner, D-Va., and Bob Corker, R-Tenn., who began grappling with the issue last year and were asked by Dodd to craft a bipartisan agreement.

The provisions are designed to give regulators the tools to conduct an orderly wind-down of a systemically significant financial firm. The provisions would expand the FDIC'S powers to resolve banks and extend them to cover systemically significant holding companies, insurance companies, broker-dealers and hedge funds.

Still, under the bill, the vast majority of firms would see no change. Most holding companies would go through the bankruptcy process in the event of a failure.

The new system would apply only to those firms that the FDIC, Federal Reserve Board and Treasury secretary, in conjunction with the president, determine are systemically important.

Even in that scenario, the Dodd bill would force regulators to first go to a private panel of three judges in Delaware and prove that they have sufficient evidence the firm is insolvent. The judges have 24 hours to object. If a majority of the judges agrees, the FDIC could then act as a receiver, most likely by setting up a bridge institution and selling off the failed company's assets.

But many observers are still scratching their heads at this judicial-review process. For starters, it isn't clear why the Dodd bill selected a Delaware bankruptcy court when most mega institutions are based in New York and regulators are based in Washington.

Others are questioning what the point is, arguing that the judges are unlikely to disagree with the president and regulators who say the failure of a critical firm is imminent.

"It's going to be tough for a couple of judges when the secretary of the Treasury tells them, 'I just got off the phone with the president. We think this company is going to nuke the economy, and if you stop us we are going to talk about you in the State of the Union,' " said Phil Swagel, a professor at Georgetown University and a former Treasury assistant secretary for economic policy in the Bush administration. "It's a speed bump. It's not totally window dressing, because it does force the executive branch to write down its arguments."

Speaking at a Pew Financial Reform Project event Thursday, Corker said that the judicial-review process needs fine-tuning and that he is already taking steps to improve that section of the bill with Senate Judiciary Committee Patrick Leahy, whose panel has jurisdiction over bankruptcy courts. Corker is mainly worried about what happens during the 24 hours that the bankruptcy court has to weigh the question.

"We have a 24-hour period for judicial review now, and candidly there's something we need to resolve," he said. "We're still talking to Treasury and others because there is a gaming period that is a hole, I guess."

But Corker insisted that some type of brake is needed on the executive branch and the regulators.

"What we don't want to have in this country are executive branch agencies who are overzealous and in essence take down companies without some process there to put that in check," he said. "There's some strengthening that needs to take place … but the slant for companies is toward bankruptcy. We've made it such for companies that resolution is really, really painful. If you go into Chapter 11, you can come back out of Chapter 11. If you go into resolution, it is no fun. It is over and done and you are gone."

There also continues to be debate over whether the FDIC should have the power to unwind a firm once the judges give their go-ahead. Critics argue the FDIC does not have enough expertise to unwind a large interconnected global institution, especially those with significant business lines outside banking.

"We would have preferred that the Treasury be named as the agency with the authority to go to the FDIC or others as contractors operating under Treasury's aegis," said Wayne Abernathy, the executive director for financial institution policy for the American Bankers Association.

The trade group's main concern is how using the FDIC to resolve the largest firms would affect the Deposit Insurance Fund.

"Our worry is that could compromise the image of the FDIC in the minds of your average depositor," Abernathy said. "And we are worried, does it really keep FDIC's assets from being pulled into a resolution appropriately, because we think the FDIC's assets should remain solely dedicated to deposit insurance coverage."

The Securities Industry and Financial Markets Association also praised the bill's focus, but said the FDIC could benefit from stronger partnership with other regulators.

"We believe the current construction in Sen. Dodd's bill is on a good track and begins to strike the right balance between the need to wind down failing institutions, eliminate bailouts, mitigate systemic risk and provide legal certainty for the credit markets moving forward," said Ken Bentsen, who heads SIFMA's Washington office.

"We also want to ensure that the primary functional regulator has a hand to play in an institution's resolution. That regulator likely will have the expertise in the structure and business activities of the failing institution that the FDIC wouldn't normally have."

The FDIC has lobbied Congress extensively for this type of expanded resolution authority and says it is up to the task.

"If we are serious about ending 'too big to fail,' then the FDIC is the appropriate agency to handle the additional resolution authority being contemplated in the House and Senate bills," said Andrew Gray, an FDIC spokesman. "The FDIC model is one of liquidation, not a model that props institutions up or bails them out. It is a harsh process and some in the industry may fear it, but it is effective, clear and it works."

He added that the agency has handled institutions of all sizes, and "would, of course, consult with Treasury, the SEC or others as appropriate."

Defenders of the resolution provisions also note the bill would require firms to outline their own "funeral plans" — or an outline of counterparty risks and a road map for an orderly wind-down.

Warner cited the funeral plans as an answer to critics' qualms about the FDIC's expertise.

"There's got to be a plan in place so if they get to this point and they say, 'It's tough, we could go,' " Warner told reporters last week. "This is a plan that your team has already signed up for, the regulators have blessed. It may not solve every problem, but I think we've put a lot of tools in place."

But some industry lobbyists have questioned whether funeral plans will work, arguing they will be out of date when problems erupt. An institution will be far more focused on salvaging itself than updating its death plan, they said.

"When the stuff is hitting the fan, do you really think anyone is going to be scrambling to update their funeral plans? Please," said one large bank lobbyist, who spoke on condition of anonymity.

The Dodd bill does not define how frequently funeral plans need to be updated. And if regulators think the plans are inadequate, an institution could face tougher standards such as higher capital or liquidity. If after two years of such penalties a bank still did not submit an adequate plan, the Fed and a systemic-risk council could begin forcing the institution's breakup.

As the ABA's position notes, there are also concerns about how to pay for a massive resolution.

Under the bill, large institutions would have to fund a $50 billion set-aside the FDIC could use to pay for the unwinding of a systemically important company. The FDIC would first use the institution's own assets, but could tap the fund after submitting a resolution plan to the Treasury.

Sen. Richard Shelby, the lead Republican on the Banking Committee, warned last week that the fund could be used to bail out a bank, rather than unwind it.

When "you put the honey pot out there, sometimes it's going to be used in unintended ways," Shelby said. "If the money's there, is it really there to bail out somebody?"

But it appears there are few alternatives.

Many observers reject the idea that the FDIC would instead have to borrow resources from the Treasury, creating the appearance of another bailout.

Still, though these and other details continue to be discussed, many analysts said the bill is moving in the right direction.

"It's a very thoughtful and credible effort at a resolution mechanism that is a fail-safe in the event of a systemically catastrophic failure," said Dan Crowley, a partner with the law firm K&L Gates. "Under this resolution [process], AIG would not exist."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.