We Have the Tools to End TBTF, We Just Have to Use Them

Twenty-nine years ago this month, as I was registering early for my freshman year of college, the government rescued Continental Illinois in what remains the largest bank resolution in U.S. history.

Although I was unaware at the time, during those years bank regulators went through incredible soul-searching to determine how they missed the warning flags at Continental, the original "too big to fail" institution. I graduated in 1988, the year of the Basel Accord.

But by the time I started business school in 1993, the pain caused by Continental Illinois and the bank failures of the '80s and early '90s had subsided and they were unceremoniously relegated to my case studies and finance textbooks. Deregulation proceeded apace. It took the catastrophic 2008 financial crisis to make Washington act, retroactively, as unfortunately has so often been the case in our country.

Fortunately, Dodd-Frank has given us the tools to finally snuff out TBTF – if only we'll use them properly.

In the days of the Continental Illinois implosion, not to mention in the deregulation days of the mid-to-late 1990s, neither the FDIC nor the Federal Reserve had the powers or tools even close to what is provided in the Dodd-Frank Act's Title I and Title II. Title I empowers the Federal Reserve to impose capital, liquidity, and leverage buffers on U.S. institutions with over $50 billion in assets and foreign banks of that size operating here. Title I is qualitative whereas Basel III, the minimum international bank uniform capital framework, to which U.S. bank regulators have been party since its origins in 1974, gives quantitative guidelines (Pillar I) for capital buffers and qualitative guidelines for risk management (Pillar I), including stress testing (Pillar II) and transparency (Pillar III).

Precisely because a resolution through the U.S. bankruptcy process is the preferred resolution framework by the FDIC and the Financial Stability Oversight Council, Title I Section 165(d) requires systemically important banks to submit "living wills," that is, resolution plans in which banks must describe in detail their business lines and legal entities (not one and the same) and how the bank would be resolved rapidly and in an orderly manner under the U.S. Bankruptcy Code. If preventing the default of a company is impossible and a resolution through the bankruptcy process were to have a detrimental effect on financial stability, then and only then, Title II, the Orderly Liquidation Authority, would give the FDIC the power to place a bank holding company, affiliates of an FDIC insured depository, or a nonbank financial institution into a public receivership process.

Perhaps fate would have it that the very month that Continental Illinois failed 29 years ago this May, the Housing Committee on Financial Services had a hearing, to hear from various legal experts whether Dodd-Frank's Title II had solved the Too Big to Fail problem. Never mind that if anything can end "too big to fail," it is Title I. Legislators should have a hearing on why Title I keeps getting thwarted. In fact, regulators, legislators, bankers, and the public should do everything they can so that Title I works. The goal is to avoid Title II at all cost. These concepts did not detract witnesses at the hearing from saying Title II was a failure or that what might be preferable would be to amend the U.S. bankruptcy code and to include a new Chapter 14 as a way to cope with resolving financial institutions.

After months researching and talking to lawyers and financial regulators and hearing contrasting views, I have come to the conclusion that Chapter 14 proponents fail to acknowledge the difference in the purpose of Title II and bankruptcy.  In bankruptcy, the purpose is to maximize the value of a firm's estate for creditors' benefit, whether on a liquidation or reorganization basis. The purpose of Title II, however, is to prevent systemic risk by a company that fails or may fail. Lehman Brothers' collapse taught us thata systemic crisis is neither a solvency nor a capital crisis, but rather a liquidity one.

If legislators keep caving in to financial lobbies, they will continue to hamstring regulators and then chastise them for not writing rules fast enough. No matter how strongly written financial regulations might end up being, it is supervisors who are key not only in monitoring how rules are implemented but also in conducting risk-based exams to evaluate how banks identify, measure, control and monitor their risks across business lines and importantly, different legal entities. The more lobbying goes on against Dodd-Frank and Basel III, and the more legislators and the media bash regulators without giving them resources, I fear that we will still be at the same impasse five years from now.

I'm off to my 25-year college reunion. I hope to attend my 30th with happier news of the state of U.S. financial regulatory reform than I shall bear now.

Mayra Rodríguez Valladares is the managing principal at MRV Associates, a New York capital markets and financial regulatory consulting and training firm. She is also on the faculty at the New York Institute of Finance.