WASHINGTON — The Federal Reserve Board's top two leaders on Wednesday defended U.S. statutory authority for resolving large company failures against criticism that the policy is a continuation of "too big to fail."
Testifying before the House Financial Services Committee, Fed Chair Janet Yellen said the Dodd-Frank Act provision allowing the Federal Deposit Insurance Corp. to resolve systemically important firms is a benefit to the taxpayer.
"That is a very important backup authority for the FDIC," Yellen said. She suggested the alternative of not having that authority in place would be a concern if "a firm were to fail and we don't know what the circumstances would be and [it] might be such that it would be difficult to resolve [it] under the bankruptcy code."
"The taxpayers would be in a difficult situation," she said.
Fed Vice Chairman Stanley Fischer made similar remarks in Stockholm, where he responded to criticism of the "orderly liquidation authority" and other Dodd-Frank provisions related to resolving firms.
Rather than preserve too big to fail, Fischer said, the 2010 law "gave us tools to reduce the probability of failure of our largest and most complex banking firms and to significantly reduce the damage that the failure of such a firm would do to the U.S. financial system and the broader economy."
Fischer responded to several lines of attacks against resolution policies. He argued that the authority to appoint the FDIC as a receiver is a necessary Plan B in situations when bankruptcy is not a viable option. The Plan B would help guarantee the stability of the financial system, he said. "The Bankruptcy Code does not direct the judge to take financial stability into account in making decisions," Fischer said, adding that bankruptcy does not provide for "government liquidity support and stay-and-transfer treatment for qualified financial contracts."
In the event that the FDIC does step in as a receiver of a failed financial institution, the agency has the authority to dip into a dedicated Treasury Department reserve known as the "Orderly Liquidation Fund" to provide funding to help manage the wind-down. Fischer pointed out that critics of the fund do not take into account how Dodd-Frank sought to protect the taxpayer.
The Fed vice chairman noted that if the orderly liquidation fund were to face a loss, it would not befall on taxpayers. Instead, he said, "these losses would be covered by assessments on major financial companies."
Although the Fed is not directly involved in implementing the OLA, the central bank does have equal authority with the FDIC in assessing firms' internal "living wills" — or resolution plans — that are meant to make large companies easier to wind down in a failure. The Fed also is writing a rule — known as the "total loss-absorbing capacity" — meant to ensure a company has enough long-term debt to be recapitalized in either an OLA resolution or a bankruptcy without taxpayer support.
Under the Fed's TLAC rule, a systemically important firm would "be recapitalized by its private-sector long-term creditors … not by the government," Fischer said.
Fischer also defended the TLAC proposal against charges that it would push firms to become too leveraged by increasing the weight of long-term debt relative to equity.
"[T]o protect financial stability, we must reduce not only the probability that a GSIB will fail, but also the damage that its failure could do if it were to occur," said Fischer, referring to global systemically important banks.
The long-term debt, he added, will act as "a thick tranche of gone-concern loss-absorbing capacity to ensure that resolution authorities will have the necessary raw material to manufacture fresh equity and recapitalize and stabilize the firm."
Ian McKendry contributed to this article.