BankThink

The Best Big-Bank Resolution Plan: Avoid Crises in the First Place

Federal Deposit Insurance Corp. Chairman Martin Gruenberg said in a speech on May 12th that if large financial institutions were to encounter financial problems today, "they would be allowed to fail and suffer the consequences of that failure."

"That was not an option available to us in 2008," he added. "I think it is an option available to us today."

Some observers believe that Gruenberg’s view signals an end to the practice of bailing out the creditors of "too big to fail" banks. But in reality, the statement by the head of the U.S. bank insurance fund is more subtle and nuanced in its implications.

Since the 2008 financial crisis, regulators have been wrestling with the question of how to resolve a large failed financial institution without causing a breakdown in the global payments system. The key driver of TBTF has not been the necessity to bail out the bondholders of large banks, but rather the need to avoid disrupting the trillions of dollars of payments and over-the-counter derivatives contracts that move between global financial institutions each day.

As I noted in an American Banker op-ed in March, higher capital requirements do not address "the political issues and real-world concerns at the heart of the TBTF issue, such as over-the-counter derivatives and related counterparty risk. Nor does increased capital address the core issues behind the 2008 market breakdown, including liquidity risk, a lack of adequate public disclosure and securities fraud related to ‘off-balance-sheet’ financing."

The FDIC has been working diligently to address the issue of counterparty risk, most recently by collaborating with the International Swaps and Derivatives Association to establish protocols for delaying the trigger on the exercise of default rights (such as termination rights and rights to net collateral) for OTC derivatives. Since OTC derivatives are exempt from the automatic stay in bankruptcy or under an FDIC receivership, swap counterparties can flee a failing bank even though bondholders and other creditors must await a resolution.

In simple terms, the new ISDA protocols prevents swap counterparties from taking their collateral and running away from a failing bank — precisely the scenario that occurred in 2008. Title II of the 2010 Dodd-Frank Act generally imposes a one or two business-day stay on the exercise of default rights, but regulators acknowledge that this interval is far too brief to allow for effective action in the event of a large bank failure.

The ISDA 2014 Resolution Stay Protocol, published on Nov. 12, 2014, provides for the voluntary adoption of a longer delay on the exercise of default rights. This regime will eventually be codified in regulations that are expected to be adopted by the Federal Reserve and other U.S. regulators in the next couple of years. Significantly, eighteen major global banks have already voluntarily adhered to the ISDA protocol, but major buy-side investment firms are refusing to follow suit.

The refusal of large investment firms to support the ISDA Resolution Stay Protocol represents a major divergence between regulators and some of the largest institutional investment firms. But thanks to the diligence of Gruenberg and other regulators, the reticence of these buy-side firms is likely to be short-lived. The ISDA protocol, by its terms, anticipates that regulators in various jurisdictions will adopt regulations in the coming years that will prohibit financial institutions from entering into OTC derivatives transactions with counterparties who have not adhered to the terms of the protocol or otherwise agreed to similar terms.

Eventual adoption of the ISDA protocol will go a long way to repairing one of the most ill-advised developments ever seen in the financial world — namely, making OTC derivatives and other qualified investment contracts exempt from the automatic stay in bankruptcy. There is no reason why the users of OTC derivatives should be given superior treatment to bond investors in large financial institutions. Yet this is precisely how U.S. law has evolved since the creation of the retrograde bilateral market for OTC derivatives markets in the 1990s. Congress should repeal this special treatment for OTC derivatives and restore a level playing field for all investors in bank obligations.

In addition to repairing the mischief done by the lobbyists for the OTC derivatives markets, regulators need to focus their attention on attempts to curb the Fed’s emergency lending powers. Under current law, a large bank experiencing liquidity problems would be forced into bankruptcy or a Dodd-Frank resolution, events that would likely trigger a massive run on liquidity similar to that seen in 2008. Some members of Congress want to place even more limits on the Fed’s ability to lend, an ill-advised initiative that would ensure a future crisis.

Policymakers need to understand that many of the initiatives taken since 2008, including Dodd-Frank, Basel III and other prudential regulations, have cumulatively reduced the liquidity of the financial markets. Increased capital requirements imposed upon nonbank mortgage firms facing the government-sponsored entities and Ginnie Mae, for example, have actually decreased volumes, profits and liquidity in the mortgage markets. By limiting the liquidity of markets and financial institutions, we make the likelihood of systemic events greater and, ironically, endanger the stability of the payments system.

Advocates of limiting the Fed’s ability to respond to market disruptions should be careful what they wish for. Instead of placing limits on the provision of liquidity in times of market stress, Congress should be looking for ways to avoid turning short-term liquidity problems into major financial crises. If we restore equal treatment for all investors of large banks while enforcing existing rules on the prudent creation of risk, we can avoid the types of market panics seen in 2008 and thus testing the FDIC’s ability to resolve large financial institutions.

Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency, where he is responsible for financial institutions and corporate ratings. He is co-author of the new book Financial Stability: Fraud, Confidence & the Wealth of Nations. Follow him on Twitter at @rcwhalen.

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