This article completes the report on a meeting conducted by the FDIC recently on its Systemic Risk Advisory Committee, a group of experts who advise the agency on the implementation of provisions of the Dodd-Frank Act that are supposed to provide new tools for the management of systemic risk.
The first article covered the morning session, in which the group received briefings on efforts to coordinate the administration of systemic risk measures with foreign regulators, although the discussion often looked ahead to the subject of this report of the afternoon agenda, namely how the FDIC plans to implement Titles I and II of Dodd-Frank.
Title I establishes a complex procedure for resolution of so-called Systemically Important Financial Institutions (SIFIs), whether banks or nonbanks, when they are designated as such by the Financial Stability Oversight Council (FSOC), which is headed by the Treasury Secretary and composed of the entire panoply of financial regulators.
Title II calls for the institutions so designated to submit the “living wills” developed under Title I to the regulators in an effort to demonstrate that the regulators are preparing to put such institutions through a bankruptcy-like process if they should get into trouble, rather than bail them out.
The philosophy behind Dodd-Frank is akin to the one that spawned the creation of the Department of Homeland Security (DHS). Much as the attacks of 9/11 are attributed to the fact that the nation lacked a DHS to centralize the measures needed to defend the “homeland,” the 2008 episode of the financial crisis is officially attributed to the lack of a group such as the FSOC to coordinate the supervision of the largest financial institutions and the lack of the tools provided under Dodd-Frank to resolve them when they get in trouble, which some experts venture to say they already are.
The most valuable service these meetings serve is to provide a window into the thinking of the best-informed observers of the condition of the financial sector and to enable the audience to witness the deflection of that wisdom by the FDIC staff, represented principally by James Wigand, director of the FDIC’s Office of Complex Financial Institutions (OCFI), who demonstrated both a comprehensive knowledge of the provisions of Dodd-Frank and an ability to fend off the insights offered by the experts, much as NHL goalies would swat away pucks if they were not on strike.
In the first afternoon session, Wigand explained that there is a relationship between Titles I and II. Title I provides for enhanced supervision, to minimize the likelihood of failure and the cost in the event of failure. The living will required under Title I provides plans for executing the resolution authority under Title II. He stated that the first option would be to use the resolution frameworks under Title II and that each firm would have unique issues and impediments that are supposed to be identified as part of the process of creating the resolution plans for each SIFI.
During the ensuing discussion, former Federal Reserve and current FDIC General Council Michael Bradfield predicted that the courts would give the agencies wide latitude in applying the resolution provisions, and he advised that it would be wise for the agencies not to be too specific in laying out how they would proceed so as not to create a potentially valid basis for an appeal by the institution subjected to resolution.
Former Federal Reserve Chairman Paul Volcker observed that the 2008 crisis “arose because of bad lending and other practices internal to the banks,” and he recalled earlier episodes, such as the 1982 Latin American debt crisis and the real estate lending crisis of the early 1990s. He suggested that the next episode might well arise out of problems in Europe, where “banks would go bust if Spain stopped paying.”
MIT economics professor Simon Johnson, a leading critic and skeptic of policies of the financial regulators during and after the 2008 episode, twice brought up a recent speech by William Dudley, president of the Federal Reserve Bank of New York, who derided the living will exercise and suggested that the documents submitted by the largest banks were of so little value that they might as well be “thrown into the ocean.” Johnson tried to impress the staff with the significance of such a statement by a leading regulator, which he called “an extraordinary event.”
Wigand was unmoved and insisted that, “We’ve found the first round of plans informative and taking us up the learning curve.”
The other leading critic/skeptic on the committee, Richard Herring, a finance professor at Wharton, questioned the emphasis by the regulators on liquidity as the likely trigger for possible action to implement resolution plans, “because one of our SIFIs is so deeply protected by deposit insurance that it’s not likely to become illiquid, even if it were deeply insolvent, and those are the ones that could be really expensive. It’s possible to be illiquid and not be insolvent.”
This time Wigand sought to deflect the shot by allowing that this was true of some community banks. (A skate save, and a beauty!)
Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City, current vice chairman of the FDIC and sometime in-house critic, theorized that “liquidity issues are really triggered by solvency fear,” and referring to the stress Bank of England head Mervyn King places on capital, Hoenig added that “when you look at those [capital] levels, in a systematic fashion right now, they’re still extremely low.”
The perspective of this writer is one of having warned the Reagan transition in 1981 that there were five huge, insolvent financial institutions that had the potential to bring down the U.S. economy if they were not subjected to a resolution process. In 1989 and 1991, Congress enacted legislation (FIRREA and FDICIA) intended to give the regulators the tools they needed to make sure that a crisis such as the one that destroyed the savings and loan industry in the 1980s would “never happen again,” but as the financial crisis unfolded over succeeding decades, those tools were never implemented.
This is why critics, skeptics, and even cynics doubt that action will ever be taken to contain embedded losses that some experts estimate to have risen to the range of $15 trillion, equivalent to the entire gross domestic product of the United States. Rather, various tools will continue to be used to sustain and bail out the largest banks and government-sponsored enterprises. As Johnson has pointed out, the size of the largest, most-troubled institutions has continued to expand, even as the authorities have proclaimed the end of the policy of “Too Big To Fail.”
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