The perils of repealing FDIC resolution powers

WASHINGTON — The Trump administration’s examination of Dodd-Frank Act powers to allow regulators to seize and unwind a failing megabank is drawing criticism from supervisors at home and abroad.

President Trump signed an executive order last month targeting so-called orderly liquidation authority, suggesting that the administration may seek to revise or eliminate such powers. Yet while the risks of curbing such powers are apparent — without them, the government may be helpless to stop the next banking crisis if the bankruptcy process proves inadequate — the benefits of removing it are more theoretical.

Many Republicans have argued that orderly liquidation authority enshrines "too big to fail" because it relies on a possible draw from a Treasury line of credit to help manage a bank's dissolution, which they say counts as a bailout. But a growing chorus of current and former regulators, both in the U.S. and internationally, disagrees.

Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said in an interview on May 15 that the bankruptcy courts could potentially resolve a systemically risky financial institution, but it would likely take time. Given the complexity of financial institutions and the additional challenge of avoiding widespread financial panic, the maneuverability of an orderly liquidation authority resolution might be exactly the tool that a future crisis calls for.

Sen. Mark Warner and Sen. Elizabeth Warren
Senator Elizabeth Warren, a Democrat from Massachusetts, right, and Senator Mark Warner, a Democrat from Virginia, speak during a Senate Committee on Banking, Housing, and Urban Affairs hearing with Steven Mnuchin, U.S. Treasury secretary, not pictured, at the the U.S. Capitol in Washington, D.C., U.S., on Thursday, May 18, 2017. Mnuchin's testimony is his first committee appearance since his controversial confirmation. Breaking up Wall Street banks would be a "huge mistake," Mnuchin told lawmakers Thursday. Photographer: T.J. Kirkpatrick/Bloomberg
T.J. Kirkpatrick/Bloomberg

“Because all of the counterparties, all of the deep connections across products, across counterparties and so that liquidity and the contagion that's possible — it’s unlike any other industry,” Harker said. “So could you put that into bankruptcy? Maybe. But I still think orderly liquidation is a useful backstop in the event that you can't get this resolved fast enough in bankruptcy. Ideally we use it rarely, but why take that away completely?”

Former Federal Reserve Gov. Daniel Tarullo argued the same view in a blog post earlier this month, saying that it is dangerous to assume that bankruptcy — even with some additional powers meant to make sense of the labyrinthine interconnections of financial institutions’ assets and obligations — could be perceived by the markets to be up to the task of resolving a failing megabank.

“There are really no good examples of systemically significant firms being resolved in a non-disorderly way,” he said.

The debate was in full view during a Senate Banking Committee hearing on Thursday. Sen. Pat Toomey, R-Pa., is leading the charge to curb orderly liquidation authority in the Senate using the reconciliation process, which would allow Republicans to bypass the need for Democratic support because it only requires a majority vote. He urged Treasury Secretary Steven Mnuchin to speed the administration's review of OLA and recommend its dissolution.

"I would just like to underscore that as you do this review of the OLA and the OLF" — the Orderly Liquidation Fund — "I hope we will keep in mind that this very convoluted construct which at the end of the day contemplates a taxpayer-funded bailout through the OLF of a failed bank, it is a creature of the fact that we don't have an adequate resolution mechanism in bankruptcy," Toomey said.

But Sen. Mark Warner, D-Va., who helped craft orderly liquidation authority in the Dodd-Frank bill, detailed the costs to the institution, including the firing of management and creditors taking losses, in an attempt to demonstrate that OLA was not a bailout. He said Mnuchin needed to be cognizant of what would happen if the government lacked such powers.

"You need some backstop there," he said.

For his part, Mnuchin sounded far less aggressive than in the past in discussing his view of such powers. Though Mnuchin had previously suggested OLA needed to go, he emphasized Thursday that he had an open mind and his review was not complete.

"Let me just assure you, we have not reached any conclusions on this," Mnuchin said. "So this is something we are looking at ... and I do share your concern. The current bankruptcy code does not work for financial institutions and liquidity is a serious concern even if we went through a bank process."

Yet the use of orderly liquidation authority, regardless of legislation, ultimately turns on Mnuchin, and the administration has the power to render it useless even without legislation.

Under Title II of Dodd-Frank, the secretary of the Treasury has the power to initiate OLA proceedings on a financial institution upon the recommendation of a two-thirds majority of the members of the Federal Reserve Board of Governors and a two-thirds majority of board members of the Federal Deposit Insurance Corp.

The Treasury secretary cannot initiate OLA without that recommendation, but retains the discretion — in consultation with the president — to weigh other factors as well, including whether the firm is “in default or in danger of default,” whether its failure could “have serious adverse effects on financial stability,” as well as considerations for whether a “private sector alternative” is available and the effect of OLA resolution on creditors’ claims.

Once that determination is made, the Treasury secretary and other financial regulators have fairly broad authority to reorganize the company, including dismissing the board of directors or other management officials, spinning off or resolving subsidiaries and moving assets. The Treasury also provides a line of credit to the parent company drawn from the OLF — a fund paid for by financial companies but underwritten by the federal government that is meant to provide public confidence and prevent runs.

While Dodd-Frank stipulates that the government may not take a loss from this line of credit, this is the aspect at the root of the president’s April 21 executive order asking Mnuchin to examine OLA and make both regulatory and legislative recommendations for revising OLA in order to “prevent taxpayer-funded bailouts” and address “systemic risk and market failures, such as moral hazard and information asymmetry.” Those priorities were laid out as “core principles” of regulatory reform in the president’s Feb. 3 executive order.

Michael Krimminger, a partner at Cleary Gottlieb and former FDIC official, said the idea that the credit line envisioned in OLA emboldens bad actors to take excessive risks seems more doctrinaire than reality.

“I fear that the obsession with trying to argue that central bank liquidity resources — the discount window, etc. — are the equivalent of a bailout is a bit of a theocratic approach to public policy,” Krimminger said. “That is the purpose of having a central bank, primarily: to provide liquidity during times of crisis.”

Banks, for their part have said relatively little on the question of repealing OLA. Greg Baer, president of the Clearing House Association, said during an April 6 hearing in the House Financial Services Committee that the statute already states a preference for bankruptcy proceedings, and the development of living wills for the largest banks makes the likelihood that regulators would ever resort to OLA very low.

“It's a backup plan,” Baer said. “I think it's unlikely to use the backup plan, but it appears to be a backup plan for which there aren't a lot of costs retaining.”

Baer added in an interview this week that, notwithstanding the oft-repeated claim that OLA enshrines "too big to fail," there is little reason to believe that banks or their investors are behaving as though there is an implicit or explicit government bailout waiting to make them whole in the face of a failure.

"It continues to be very difficult to find any evidence in markets that debtholders in large bank holding companies think OLA reduces their exposure," Baer said. "They certainly don’t seem to be pricing for it."

Paul Kupiec, a resident scholar at the American Enterprise Institute and former FDIC official, said the point of repealing OLA is that it is redundant to bankruptcy. And the reason bankruptcy courts are preferable to federal regulators in resolving a failing bank or other institution is because bankruptcy follows rules — specifically case law — in deciding which creditors get repaid and which do not.

“Part of the deal with the bankruptcy court is, there's case law that determines which investors have rights and priority of claims and things like that, and the FDIC can do what it wants in some cases, claiming, 'We need to violate claims priorities and put losses on somebody and not somebody else,' ” Kupiec said. “Courts can't do that.”

Kupiec added that judges, unlike federal regulators, have primarily legal questions to consider rather than political — or even practical — considerations. That means there is less potential for which creditors get paid back and which do not being influenced by the outcomes for preferred companies or constituencies — regardless of who is in power.

“It's going to be a different standard,” Kupiec said. “If there is some issue of systemic risk, the standard of proof to show it is going to be different than the FDIC, which basically answers to the administration in power. The judge, you would think, is less political in whatever it is they do.”

It is also true that financial crises tend to involve the potential failure of many institutions at once. Kupiec said it seems unlikely that FDIC could resolve several SIFI banks using OLA at the same time without exacerbating the financial panic that the authority is meant to quell.

But Krimminger said, by that same token, several SIFI banks in bankruptcy court would also probably not settle the markets’ nerves, either. And if 2008 is any indication of future crises, he said, institutions tend to get into trouble in sequence rather than at the exact same time — so a swift and effective intervention by authorities at the right time might keep other institutions from needing OLA or bankruptcy.

When counterparties "pull away from one bank, they might be pulling away from others, but the market tends to do it sequentially,” Krimminger said. “If you can achieve an orderly resolution, it would likely calm the markets and provide some time for the other institutions to deal with their issues.”

Another critical question is whether any revision or elimination of OLA would effectively nullify cross-border agreements in place between the U.S. and EU. Valdis Dombrovskis, head of the European Commission’s Financial Stability, Financial Services and Capital Markets Union, said in a speech in Washington in April that Europe wants to “maintain and improve” regulatory cooperation between the two jurisdictions.

“To do so, both EU and U.S. laws need crisis management tools which are compatible with each other,” Dombrovskis said. “So we are following very closely discussions on a possible modification to the Title II of Dodd-Frank on the orderly liquidation authority. We hope the need for effective cooperation will be taken into account in these discussions.”

Karen Shaw Petrou, managing partner of Federal Financial Analytics, said the banks have tried to be somewhat muted in their opposition to an OLA repeal because a more forceful opposition would likely spur a backlash.

Yet the April executive order poses a more immediate concern because it sent the message that, at least for the time being, the Treasury secretary would not be invoking OLA. That could embolden European regulators to demand that U.S. banks doing business there should hold additional capital or otherwise insulate their risks and operations from the U.S. parent company.

"The fear is that if they're seen as obviously defending it, that will only reinforce the wrong impression that OLA is a big-bank bailout, so they're saying quietly ... the prospect of the kind of disorderly failure in the absence of Title II and the much more immediate threat from foreign governments is a serious challenge," Petrou said. “If the European regulators don't trust the way in which the U.S. would resolve a giant bank — and without OLA they won't — they will ring-fence the U.S. banks into home-country subsidiary operations.”

Kupiec said those agreements between U.S. and European regulators go both ways. Given how few U.S. banks really have substantial operations in Europe and how much better capitalized U.S. banks are versus their European counterparts, there is little risk in retaliating against European banks operating in the U.S. if the EU makes those kinds of moves.

“Europe doesn’t stick to these agreements — U.S. banks are way better capitalized than European banks,” Kupiec said. “You can have agreements, but what are they worth? It’s a good political argument to make, but I don’t buy it, in the end.”

Baer said the idea that U.S. banks are better situated to prevail in a cross-border capital ring-fencing arms race with Europe may well be true, but that doesn't mean that it doesn't pose a significant threat.

“There are a lot of examples of arms races where both sides lose,” Baer said. “I think that could be a likely outcome.”

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Dodd-Frank Bankruptcy Steven Mnuchin Jeb Hensarling Treasury Department FDIC Federal Reserve
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