WASHINGTON – The Federal Deposit Insurance Corp. was concerned about the interconnectedness of the financial system years before the 2008 crisis. Joseph Fellerman, a former top researcher at the agency, was part a tiny team that analyzed systemic resolution, and how regulators could tackle large-scale failures.

As such, Fellerman, who first joined the agency in 1976 and left last year, was on the front lines of the FDIC's evolution throughout the 2008 crash.

"I won't say that we were necessarily a backwater institute, but the fact of the matter is we're an insurer and our relationship wasn't necessarily at these large bank levels," he said. Now, "one of its major primary responsibilities is being ready to be the resolver … of one of these large companies."

In a sit-down interview with American Banker, Fellerman shared his views on the transformation of banks – and the FDIC – and what remains to be done to ward off the next crisis. Following is an edited transcript.

When did the agency start becoming concerned about the resolution of large banks?

I went to the division of research in the early 2000s. One of the things that I was doing was evaluating the concentration of the industry. And we started getting very concerned about the increasing concentration of assets within the top quartile of banks, especially the top 10 banks. And also about the ability the FDIC had to actually resolve one of these very large banks, both from a policy standpoint as well as a systems standpoint.

It became a very widespread concern within the FDIC. We started doing a series of projects to improve the IT systems and we also started preparing policies and procedures regarding very large banks.

Closing small banks – we had done in the past. It's a very bureaucratic process, it's very regimented, and everybody knows what to do. For very large banks, it's completely different.

So the FDIC was preparing itself structurally for this?

Yes, we actually developed a very large simulation with the assistance of Booz Allen [Hamilton]. We did a series of simulations that involved our board and … other regulators. [They involved] just walking through how we would do one of these in a pretty detailed … real-life kind of exercise.

The last [big simulation] was in 2007. It's very fortuitous that we were doing this prior to 2008, so our board was actually pretty well-educated on what the FDIC's responsibilities and capabilities are. Obviously, 2008 blew that wide open.

[The FDIC, the Federal Reserve and Treasury Department] had to basically develop programs on the fly and what to do to stop the contagion effects after Lehman.

In what ways did the simulation help regulators prepare?

To the extent that you could think the unthinkable. … We combined balance sheets of a variety of firms to anonymize the bank that was the subject of the simulations, but it was a very large firm. And it helped inform, at least for the bank, the board of directors and senior management, what is normally on the balance sheet of these firms, at a very detailed level and what the liabilities look like.

And also, the optionality of what could the FDIC do to those firms? We couldn't just sell it to another firm. Because then you'd have a super large company.

But … it turned out [that] Washington Mutual was purchased by JPMorgan, which was already one of the largest banks in the world.

How did the single point of entry emerge in banks' living wills?

The first living wills in 2012, if you read the rule, were actually to consider a multiple point of entry [an approach where the company's subsidiaries are resolved separately]. Basically, mimic Lehman's failure.

There was no intent actually on the first plans to reach any conclusion regarding credibility or noncredibility. The rule gave them the first one as a gimme. We knew that they would have to staff up and think about the issues themselves.

The second plans in 2013 were allowed to consider single point of entry or multiple point of entry. The firms were given a free hand to pick their preferred strategy, and also an alternative strategy if they wanted to. The greatest vulnerability [in single point of entry for these firms] that they saw was the derivative unwind, because at that point in time in the Dodd-Frank Title I, in bankruptcy derivatives are resolved outside of bankruptcy.

And that's where the development of the [International Swaps and Derivatives Association] protocol … came into play. Eventually, all written contracts would allow for transitions in either [a] bankruptcy or in a regulatory intervention to a surviving entity – as long as … the payments were still being [made]."

If you saw the feedback letters that were released [in April], [they] were very much in the same format and in many places word for word [compared to the regulatory feedback to the 2013 living wills].

Weren't they more detailed?

This time around they were more detailed yes. Because there were so many issues raised in the 2013 ones, there was no reason to get detailed. [That year], they didn't even succeed at the very high level.

Has there been an increase in communication between the FDIC and the firms?

Yes, [there was a] dramatic increase after the 2014 letters. It was basically an open house. You can call us, we can call you.

I won't say that the messaging before was cryptic, but there was a lot of concern from the legal side about confidentiality of information. If you tell one company one thing, you have to tell all eight or nine or 11 the same thing.

After 2014, the concept was, these guys are big boys. Let them ask their questions and we'll answer their questions as best we can.

How does the FDIC see its own role in systemic resolution planning?

Right now it [considers that] … one of its major primary responsibilities is being ready to be the resolver under Title II of one of these large companies.

[Before,] we were a regulator, primarily of smaller companies. And I won't say that we were necessarily a backwater institute, but the fact of the matter is we're an insurer and our relationship wasn't necessarily at these large-bank levels.

Could the regulators have been better prepared for the 2008 crisis?

Oh yes. But I think it was so out of the realm of what was considered probable that it just wasn't considered important enough. The FDIC was concerned mainly because those firms were so large [and] the [Deposit Insurance] fund is relatively small. We had a lot of concerns over systems.

But in terms of policies and procedures, one of the things that was absolutely interesting during the crisis [was that] the old rulebooks were just thrown out.

And part of this was that this was such a crisis across the entire industry that they had to really come out with out-of-the-box solutions.

Today, are the better banks better guarded against systemic risk?

Light-years. I don't think they're prepared for Title I resolution [without government assistance] but … for Title II, I think, because of the strides the industry has made.

They made strides in shared services, in terms of actually recognizing, identifying and formalizing shared-service contracts so that critical operations could continue.

There were a lot of strides made, and I think that was the point of the initial iterations, that the plans and the feedback was first to get the firms to understand these vulnerabilities, and second to start addressing them.

I think the FDIC and the Federal Reserve's understanding of these firms is much, much better [too]. And I really do believe that a Title II resolution has a very high probability of success. Now, there [are] other issues – [including] whether you can do one [firm's resolution] without systemically disrupting others. But there [are] other mechanisms to try to staunch that as well.

How do you feel about the current political rhetoric on breaking up big banks?

They certainly don't take into account the advances we've made. It's rhetoric from five years ago, six years ago. I think today, the industry in fact is much safer. Part of it is due to the recovery of the economy. The firms are much more liquid, they have much more capital. They still have a long way to go. But it's not a long list enough to be the campaign topic, I can't even think.

Was Dodd-Frank well thought out?

I think it had incredibly good points and then very weak points.

The weakest one – Title I – goes back to my original concerns that bankruptcy for these firms fails to address the liquidity needs and fails to consider the issue of the derivative unwind outside of bankruptcy.

Title II remarkably enough does provide for liquidity, in a significant amount. It provides for a timeline that is more than enough, I think, to resolve any of these companies from a regulatory standpoint, and it provides the power and the delegations to do that.

I think there is going to be a point in the future where the optionality will be available to … have separate resolutions in different parts of these firms. [So that] you are able to separate out different sections of the company without interfering with the [firm's] operations.

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