The financial crisis produced the worst economic recession in the United States since the Great Depression, leading to the near-total collapse of the global financial system, wiping out retirement savings and costing millions of Americans their jobs, homes and livelihoods. At the height of the crisis, Lehman Brothers collapsed into disorderly bankruptcy, causing panic throughout the financial system. American International Group was bailed out by the government, prompting widespread revulsion and exposing taxpayers to extreme risks. President Bush and Congress stepped in to pass the Troubled Asset Relief Program, which, though essential to stem the panic, was one of the most reviled economic programs enacted in modern memory.

In response to the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, to help make the financial system safer and fairer. Dodd-Frank strengthened oversight of the largest banks, provided a mechanism to ensure supervision of firms like Lehman and AIG that had previously escaped Federal Reserve regulation, created tough new rules for derivatives trading, and bolstered consumer and investor protection. But one of the law’s key measures was the Orderly Liquidation Authority, which for the first time provided the Federal Deposit Insurance Corp. with the tools it needs to deal with the failure of a systemically important firm.

Now, President Trump has directed his Treasury secretary to target the OLA, and House Financial Services Committee Chairman Jeb Hensarling has unveiled a plan to scrap it, which passed out of the House Financial Services Committee earlier this month. Eliminating the OLA would be a serious mistake that would recreate the very conditions that made the financial crisis so disastrous for the country.

Lehman Brothers' bankruptcy
A man leaves Lehman Brothers’ headquarters on Sept. 15, 2008. The investment bank’s bankruptcy caused a seismic shock in the financial system. It would be foolish to rely solely on bankruptcy judges to manage such a failure again. Bloomberg News

Why is the OLA important? When a traditional bank or thrift is either failing or on the verge of failure, the FDIC has long had the authority to step in to guide the failing institution through a process that limits collateral damage, and protects taxpayers and the broader economy as a whole. As the financial crisis demonstrated, though, with respect to failing nonbank institutions like Lehman Brothers or AIG, or complex bank holding companies, the only available options were bankruptcy or government bailouts, both of which proved unacceptable.

When Lehman Brothers entered into bankruptcy in September 2008, it caused a seismic shock in our financial system. The complicated web of Lehman’s financial obligations left balance sheets worldwide exposed to a cascade of default risk, and contagion spread the risk throughout the financial system. It would be foolish to rely solely on the hope that bankruptcy judges, even if the House-passed bill were to become law, could manage the failure of a financial institution of the size, complexity and interconnectedness of Lehman, AIG or the largest U.S. bank holding companies, insurance conglomerates or investment banks.

Orderly Liquidation Authority has three essential features that cannot be replicated in bankruptcy: First, supervision, planning and management. The OLA relies on the management of a resolution by the FDIC, an expert agency with a large, dedicated and experienced staff. Supervisors, seeing deep financial stress at a firm, can put the firm into resolution, restructure its capital and debt, and create a bridge institution for its ongoing operations — before it is too late. Pre-failure planning is also aided by other provisions in the Dodd-Frank law. Resolution of a failing firm is part of an integrated system of ongoing supervision by the Fed and FDIC, including stress tests, living wills, pre-placed capital and convertible debt.

Second, the availability of FDIC-provided liquidity in a crisis through the Treasury Department’s “orderly liquidity fund,” which is backed by the firm’s assets, when private-sector lenders are likely to balk. Without that, resolution is a fool’s errand and likely to spark widespread panic. Taxpayers are fully protected by the firm’s collateral and by automatic assessments on the largest financial institutions should such assets prove insufficient.

Third, global coordination with foreign regulators, based not only on prenegotiated legal memorandums of understanding, but also on collaborative war-gaming, communications and, most important, the development of a trusted relationship between the FDIC and other overseas regulators earned over time. The FDIC quickly went to work developing cross-border MOUs after the law was passed.

Bankruptcy, even if reformed, cannot replicate these three essential features.

To eliminate OLA is to consciously forget key lessons of the financial crisis. It is to carelessly throw away a useful and necessary tool and blind oneself to the amount of risk the failure of large, complex financial institutions pose to our financial system. Without OLA, a central and known problem that contributed to our last financial crisis will become a core problem of our next one. We have enough work still to do on the path of reform without undermining our progress thus far.

Michael S. Barr

Michael S. Barr

Michael S. Barr is the Roy F. and Jean Humphrey Proffitt Professor of Law and Professor of Public Policy at the University of Michigan. He previously served as assistant secretary of the Treasury for financial institutions in the Obama administration.

BankThink submission guidelines

Want to contribute to BankThink, American Banker's platform for informed opinion about the ideas, trends and events reshaping financial services? View our detailed submission criteria and instructions.