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Fed's Plan for Unwinding Behemoths Won't Cut It

As regulators continue to develop and implement plans for resolving failed megabanks, it is crucial that Wall Street insiders are forced to internalize the risks of losses from a future crisis instead of imposing those losses on society. Unfortunately, the Federal Reserve Board's most recent proposal requiring "total loss absorbing capacity" has a long way to go before reaching that goal.

The Fed's TLAC proposal identifies "single point of entry" as the government's chosen resolution path. The "single point" plan, which the Federal Deposit Insurance Corp. has focused on as an approach for handling big failures as authorized under the Dodd-Frank Act, would wipe out failed holding companies but keep subsidiaries open. Since this strategy would effectively give 100% protection to Wall Street creditors, and Dodd-Frank makes public financing available to the FDIC, it is no wonder that Wall Street has embraced both SPOE and TLAC.

Under SPOE, all losses from a resolution will be imposed on shareholders and long-term, bail-in debtholders of the holding company. Creditors of the subsidiaries — including uninsured depositors, commercial paper holders and counterparties under securities repurchase agreements and derivatives — will be insulated against losses.

To make sure the FDIC has more resources to deal with megabank failures, the Fed's TLAC proposal requires holding companies to have higher levels of capital and long-term debt to absorb losses. But the plan raises too many questions and risks preserving "too big to fail" subsidies.

For example, the Fed plans to impose steep capital penalties to deter banks from buying TLAC debt issued by megabank holding companies. In contrast, regulators appear willing to allow institutions to sell their TLAC debt to mutual funds and pension funds. Regulators apparently view ordinary individuals as "non-systemic" investors whose savings can be wiped out without threatening financial stability.

Additionally, it is not clear whether the FDIC still endorses the single-point-of-entry plan as described in the Fed's TLAC proposal. The Fed, which consulted with the FDIC, cited as part of its proposal the FDIC's 2013 paper discussing how single-point-of-entry would work. That paper was broadly consistent with Wall Street's favored SPOE strategy. But the FDIC's position has seemed to evolve.

In a Sept. 17 speech FDIC Chairman Martin J. Gruenberg said his agency plans to conduct a "breaking up and winding down" of a failed megabank during an "orderly liquidation authority" resolution. He also stated, "An explicit objective is to ensure that no systemically significant entity emerges from this process." Those statements don't square with the Fed proposal's endorsement of Wall Street's version of SPOE.

The Fed must change the TLAC proposal to ensure that failed megabanks are broken up during OLA resolutions, as indicated by Gruenberg. Otherwise, SPOE and TLAC will perpetuate TBTF subsidies for megabanks. After Lehman Brothers failed, federal authorities provided a 100% backstop to protect the uninsured deposits and shadow banking liabilities of other megabanks. SPOE and TLAC would give Wall Street creditors a similar 100% guarantee while imposing the costs of future megabank failures on ordinary citizens once again.

Instead of giving in to Wall Street's SPOE strategy, Congress and regulators must insist on four additional reforms that would reduce TBTF subsidies for megabanks, their executives and Wall Street creditors. First, megabanks must satisfy all or most of their TLAC requirements by issuing Tier 1 equity capital. Tier 1 equity provides a superior buffer for absorbing losses, because common stock and non-cumulative perpetual preferred stock do not have maturity dates, do not have fixed obligations to pay interest and can suspend dividends to conserve capital. The Fed's proposal is therefore plainly wrong in saying that megabanks should satisfy almost half of their TLAC requirements by issuing bail-in debt.

Second, all newly issued TLAC debt must be marketed and sold as subordinated debt. A subordinated debt requirement would minimize the risks of misleading investors. It would also require megabanks to pay higher interest rates that would more fairly compensate investors for the extraordinary risks inherent in TLAC debt. Megabanks might well decide to avoid paying those interest rates by issuing larger amounts of Tier 1 equity capital. That would be a highly desirable outcome.

Third, megabanks must pay risk-adjusted premiums to provide the "orderly liquidation fund" — a government-backed facility that will help the FDIC finance resolutions if a firm's bail-in debt is insufficient — with at least $300 billion of prefunding. The required premiums must include fees on uninsured deposits and shadow banking liabilities, in view of their 100% guarantee under SPOE and TLAC. A prefunded OLF would reduce the risk that taxpayers would have to bear the burden of resolving failed megabanks.

Finally, megabanks must pay a large portion of their compensation for senior executives and other key insiders in the form of bail-in debt. Insiders should not be allowed to hedge, sell or convert their bail-in debt into stock until several years after their employment ends. Requiring insiders to receive much of their compensation in bail-in debt would encourage them to follow prudent business strategies that are consistent with the interests of other long-term creditors, including the FDIC and taxpayers.

Art Wilmarth is a law professor at George Washington University Law School. 

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Law and regulation Dodd-Frank SIFIs
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