FDIC Grapples with Resolution Issues of Dodd-Frank

Thursday, 20 Dec 2012 12:52 PM

By Robert Feinberg

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The FDIC held the third meeting of its Systemic Risk Advisory Council this month, a daylong event featuring staff presentations to a group of leading experts. Several members were delayed or unable to attend the meeting at the FDIC’s headquarters in Washington due to foggy conditions in New York that day. The agenda covered issues related to cooperation with international authorities in implementing resolution plans for possible failures of the largest financial institutions and implementation of Titles I and II of the Dodd-Frank Act. This article covers the international aspects, and a subsequent article will cover the Titles I and II presentations.

While waiting for a couple people to come out of the meeting, one is struck by the incongruity of a public display that has been installed in the lobby. A banner proclaims the theme “History of the FDIC: Confidence and Stability.” Evidently the FDIC is suffering from a severe case of institutional amnesia.

The star of the day was Paul Tucker, deputy governor of the Bank of England (BOE) and a member of the international Financial Stability Board. Tucker began his presentation by identifying the valuation of bad assets and the allocation of losses as major issues, along with the danger that value would be destroyed if the entities went through a bankruptcy process (some commentators disputed that the alternatives actually achieve better results). The BOE and FDIC released a joint paper on plans to establish a single point of entry for the administration of resolutions of failed systemic banks.

Tucker went on to explain that the plan is to push losses from the bank up to the holding company, zero out the shareholders, impose haircuts on secured creditors and require some debt holders to convert their claims into equity. Management responsible for the failure would be ousted, and in the United States, a bridge bank would be created that would receive temporary federal funding in the interest of allowing the critical functions to continue to be performed despite the failure of the holding company.

Tucker then observed that this process would require making valuations up front, but the scale of the losses usually emerges only after the fact. He stated that a resolution operation wouldn’t work “where an institution were totally toxic or its records threadbare,” and he acknowledged that there were some of each during the 2008 financial crisis. (This begs the question of why the supervisory authorities, which have their personnel embedded in the largest banks, would allow this condition to persist, but that has been the history of the regulatory failure that enabled the crisis.) He added, “There is continued debate regarding how long [the valuation process] would take and the need to have decent books and records.”

Several members of the Committee raised troubling questions following the presentation, and Tucker gave remarkably candid answers, especially compared with his U.S. counterparts.

Former Federal Reserve Vice Chairman Donald Kohn predicted that up-front valuation would be extremely difficult, and he asked whether the holding company would have sufficient capital to absorb further losses during the resolution. Tucker responded that this would have to be the subject of continuing dialog between the authorities of the countries involved.

When another member asked a follow-up question based on the lack of agreement among the authorities, Tucker raised the issue of proper valuation of assets and provision of a capital cushion based on expected losses, beyond those provided under the accounting rules. (This begs the question as to why, at least in the United States, regulatory accounting rules are generally weaker than the generally accepted accounting principles practice.)

Richard Herring, a finance professor at Wharton, said that while he is impressed with the progress that has been made, he does not understand the process of pushing losses from the bank up to the holding company, and this issue reminds him of the troubled doctrine that the holding company is supposed to act as a “source of strength” for the bank. Tucker responded that banks have to be structured in a manner that would make them resolvable, and Herring rejoined that this strategy places a premium on the determination of insolvency.

Simon Johnson, professor of global economics and management at MIT, has questioned whether the resolution process can work, and after the staff presentation, he again said that based on meetings he has attended with industry groups, he doubts that the largest institutions are resolvable.

Later another member dared to point out that the authorities tend to assume that the failure will conveniently be of a single systemic bank, but this was not the case in 2008 and probably would not be in the next episode. Herring then questioned why information on the operations of systemic banks in various countries is treated as proprietary and not released as part of the public portion of so-called “living wills.”

Former Federal Reserve and current FDIC General Counsel Michael Bradfield suggested that complex organizations should be required to follow a model structure in order to eliminate incentives for regulatory arbitrage.

I believe that large, chronically insolvent banks needed to be put through resolution 30 years ago in order to avoid serious damage to the U.S. economy, but instead, as Johnson has said, they have been allowed to continue to grow with the benefit of government support. I have speculated that embedded losses have grown to approximately $15 trillion, which is equivalent to the entire gross domestic product of the US, and the Federal Reserve Bank of Dallas has recently reported a similar figure. Much of the drama of this phase of the crisis concerns how the authorities will manage this problem that is largely of their own creation.

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