As Congress considers systemic-risk resolutions, two recent cases show exactly how to wind down big banking organizations without a bailout.
Some have argued that this means no systemic resolution authority is required. However, a close examination of the two cases — CIT and Capmark — shows how different they are from other large, complex banking organizations. Unless or until other banks are disentangled from their nonbanking affiliates, no large bank holding company could go into bankruptcy and leave an operating, viable insured depository.
The ability of CIT and Capmark to file for bankruptcy at the parent level even as insured depositories remained open is precedent-setting. In the past, bank holding companies and banks lived or died as one. Wrenching apart big companies is vital to ensuring orderly liquidation. As a result, these two cases are important not just to financial markets but also to policy deliberations on breaking up too-big-to-fail banking companies.
The CIT and Capmark banks stand even as the parents fell because of the unusual nature of both companies. Virtually every other large bank holding company could not be resolved this way without new legislation. Little-noticed provisions in the House regulatory reform bill address this issue by, for example, limiting the degree to which insured deposits can be used for proprietary trading and sharply curtailing the degree to which banks can buy troubled assets from nonbank affiliates.
CIT and Capmark did not have time to grow into complex, interconnected companies, so their resolution was far more orderly than anyone should expect from other companies in the absence of a new law.
Because CIT and Capmark are new bank holding companies, they were not inextricably intertwined with their subsidiary banks. Further, the banks themselves are involved in straightforward lending activity. Both factors sharply differentiate these cases from the more usual ones.
At Citigroup Inc., for example, the bank itself funds an array of proprietary trading, private-equity and similar activities, and it operates through hundreds of overseas branches that ramify the global impact of any problems in the United States. This complexity also characterizes many other large U.S. banking organizations, as does their interconnectedness — that is, the degree to which hedge funds, private-equity firms, large corporations and other entities with systemic-risk potential rely upon them for support.
In fact, before the crisis, the parent companies were wholly separate entities using insured depository subsidiaries for limited purposes. Though the subsidiary banks are large ($9.3 billion in the CIT bank and $10.5 billion in Capmark's), the parent companies are considerably larger. Upon becoming bank holding companies, both tried to downstream as many assets as they could into the subsidiary banks to fund as much as possible with insured deposits, and CIT also sought access to the Temporary Liquidity Guarantee Program to get an FDIC guarantee for parent company debt.
However, TLGP access was denied and the Federal Reserve, under pressure from the Federal Deposit Insurance Corp., limited the degree to which holding company assets could be downstreamed into subsidiary banks. For CIT and Capmark, prior distinctions between subsidiary banks and parent firms combined with regulatory caution to insulate the insured depositories. Further recognizing the growing risk, regulators sought to enforce the "source-of-strength" doctrine, which requires holding companies to support subsidiary banks.
This is often difficult to do in traditional bank holding companies, where the parent is essentially the publicly traded shell surrounding an insured depository. When a bank is all there is in a bank holding company — the case with most large, complex banking organizations — there is no parent to support the subsidiary insured depository. However, the agencies were able to get Capmark to downstream $600 million in equity to the subsidiary bank before the parent's bankruptcy. Unless or until bank holding companies are restructured to ensure that they can in fact back their banks' bets, these bankruptcies cannot be repeated for any but the most unusual or small institutions.
CIT and Capmark are the only large examples of holding companies in which the parent went into bankruptcy but the bank remained open. There is, however, one example of a complex, systemically risky firm in which a regulated entity survived the parent's collapse. Some have raised this case to suggest that no new systemic-risk resolution regime is required, but close examination also shows why the example does not apply.
The case is the 1990 failure of Drexel Burnham Lambert. As the investment bank collapsed, the broker-dealer subsidiary regulated by the Securities and Exchange Commission survived, largely due to the broker-dealer net capital rules applicable to the subsidiary and the negligible risk it took on behalf of the parent's junk bond operations.
This is analogous to the CIT and Capmark cases because a regulated subsidiary was capitalized and insulated from the parent. The complexity of even the most ambitious investment bank in 1990 was nothing to that of today's behemoths, nor was Drexel as interconnected at either the parent or broker-dealer level to anything like today's degree.
Thus, here, too, was what cannot be, unless or until new legislation breaks apart large, complex banking organizations and makes parent company bankruptcy again a viable option.