Treasury endorses FDIC failure cleanup powers — with caveats

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WASHINGTON — The Treasury Department struck a middle ground Wednesday in long-awaited recommendations for Dodd-Frank Act wind-down powers, resisting calls to repeal those powers but still addressing concerns that the provisions are too generous to large firms.

Conservatives have long argued that the "orderly liquidation authority" should be eliminated because the process could enable future bailouts, but backers of the Dodd-Frank authority — under which the Federal Deposit Insurance Corp. can be appointed receiver for a failing behemoth — say OLA is a necessary backstop in cases when the bankruptcy process could shock the financial system.

The Treasury report, one in a series directed by President Trump to recommend ways to streamline financial regulations, is an appeal to both sides. It argued that OLA could indeed be necessary as a last resort, but also seeks to restrict the FDIC's authority, including how the agency settles creditor claims and funds a resolution. Meanwhile, the plan proposes a new bankruptcy code chapter — Chapter 14 — just for financial firms, to make OLA less necessary.

"It’s a thoughtful proposal. Bankruptcy has always been the first choice,” said Sheila Bair, who ran the FDIC when Dodd-Frank was drafted and the OLA was first implemented. “OLA is supposed to be a backstop. So in that regard, it is consistent with and preserves current law.”

Here are key takeaways from Treasury's recommendations:

OLA survives another day

The report acknowledges concerns about the wind-down regime that it attempted to address with proposed reforms, but the biggest question was whether the administration would support calls for OLA to be repealed.

The Treasury report came out on the side of retaining the resolution framework, agreeing with backers of the provision that there are cases where an FDIC resolution is the only appropriate choice to prevent a failure from having a contagion effect.

"A reformed OLA process — with predictable, clear allocation of losses to shareholders and creditors — is a far preferable alternative to destabilizing financial contagion or ad hoc government bailouts,” the report said. It added, "Without the assurance of OLA as an emergency tool, foreign regulators would be more likely to impose immediate new requirements on foreign affiliates of U.S. bank holding companies, raising their costs of business and harming their ability to compete internationally."

That approach won accolades by market watchers and some in the industry who said eliminating OLA would have negative repercussions.

Fitch Ratings "believes elimination of OLA could expose the banking sector to significant systemic risk in a crisis,” said Joo-Yung Lee, head of North American banks and managing director at the ratings firm.

Greg Baer, president of The Clearing House Association, agreed that Treasury took a balanced approach.

“The Treasury Department has proposed thoughtful steps to preserve the availability of OLA as an emergency tool, but rationalize the process for invoking it and reduce the likelihood of its being necessary through practical bankruptcy code reform," Baer said in a statement. "This proposal seems to strike the right balance between ensuring the availability of liquidity support in the event of an extreme crisis but making it even more unlikely that such support would ever be necessary.”

Free-market conservatives are not happy

The report, however, appeared to ruffle feathers following repeated calls by the GOP base to repeal OLA.

Critics of the authority, who have called for its elimination ever since Dodd-Frank was enacted, say it hands too much authority to the government to choose winners and losers in a firm's failure. They have largely supported keeping the pre-Dodd-Frank process of financial holding companies being resolved through the bankruptcy process.

"Although I have been pleased or even excited about Treasury’s previous reports" on financial regulation, "this one disappoints," House Financial Services Committee Chairman Jeb Hensarling, discussing the OLA recommendations, said in a statement. He said the report was not consistent with one of President Trump's "core principles" about regulation regarding the avoidance of taxpayer-backed bailouts.

"Dodd-Frank’s Orderly Liquidation Authority expressly enables taxpayer-funded bailouts; it does not prevent them," Hensarling said. "It is therefore difficult to square today’s report with the President’s clear guidance on this issue."

Treasury still backed more limited FDIC powers

Despite its support for preserving the powers, Treasury still sought to address concerns about OLA by proposing new curbs on how the FDIC manages resolutions.

In April, Treasury Secretary Steven Mnuchin articulated a vision in which he suggested that neither the OLA nor the bankruptcy process is perfect. However, several of the recommended reforms to the Dodd-Frank powers would require new legislation.

“There are certain big concerns we have with OLA,” Mnuchin said in April. “We don’t want that to be used to support 'too big to fail.' On the other hand, there are aspects of the bankruptcy code right now that do not work for a financial institution that is in crisis. We’re going to fix that."

The report proposed stripping the FDIC’s authority to treat similar creditors of a failed company differently, repealing the tax-exempt status of bridge companies, and using more private-sector lending to provide resolutions with liquidity. Critics of the regime have long argued that Dodd-Frank gave the FDIC too much discretion, especially in choosing how to deal with creditors when unwinding a firm.

“Uncertainty concerning how competing classes of creditors will be treated is inconsistent with the rule of law and impairs the ability of market participants to price, monitor, and limit risk in the financial system,” the report said.

An FDIC spokesman said Wednesday that the agency was reviewing the report, but he did not address the proposed changes to the FDIC.

“We appreciate the report’s acknowledgement of the importance of the Orderly Liquidation Authority as a backstop to bankruptcy for the orderly failure of a large, systemically important financial institution, and we will review the report’s recommendations,” the FDIC spokesman said in an emailed statement.

The report also proposed granting more authority to a court that must review the government's decision to invoke orderly liquidation authority. Under Dodd-Frank, the court can review only two of the government's seven determinations, but a court could review all seven under the new proposal.

The report's recommendations to create "additional hurdles to invoking OLA and Bankruptcy Court review of claims” are “not necessary,” Bair said. “But overall it’s a balanced, thoughtful proposal.”

A new bankruptcy code for 'too big to fail' firms

Another big change in the report is a proposal to create a new “Chapter 14” bankruptcy process that would be similar to how bankruptcy works now but have added requirements specific to creditors of a complex financial firm.

Treasury said creating a specialized bankruptcy process for financial companies could reduce the necessity of the government needing to rely on OLA.

The Treasury’s recommendations “are trying to build into the current bankruptcy process the ability to handle large financial failures with controls that are fair and transparent to the market,” said Thomas Vartanian, senior counsel at Dechert LLP.

“This is a very practical and smart blending of the interests of the government and private markets with regard to the handling of future financial crises.”

What’s next?

Most of Treasury's suggestions would require a legislative change, which is “more challenging than regulatory changes,” Lee at Fitch Ratings said.

“The ultimate impact to creditors will depend on what, if anything is changed, though the credit implications appear limited at first review,” Lee added.

There is some support from Republicans on creating a new bankruptcy process for failing financial giants, but persuading some lawmakers to keep both the OLA and a new bankruptcy code may be difficult. Rep. Dave Trott, R-Mich., told Mnuchin during a hearing earlier this month that his preference was that a new bankruptcy code replace the OLA.

“I happen to believe that a new subchapter in the bankruptcy code is a much better way to deal with an insolvent financial institution than political appointed bureaucrats sitting in secret in a private room,” Trott told Mnuchin during the Feb. 6 House Financial Services hearing. “You go to bankruptcy court, you've got an experienced judge who is going to make a decision based on years of precedent; it's going to be open and transparent.”

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