‘Too-big-to-fail’ reform is laudable but unlikely

On Wednesday, the Treasury Department proposed a major reform of the process for ensuring the orderly resolution of large, troubled financial firms — those that supposedly are “too big to fail.” That process currently is spelled out in Title II, Orderly Liquidation Authority (OLA), of the Dodd-Frank Act (DFA) enacted in 2010.

Fortunately, the OLA process has gone untested in the eight years that it has existed due to the continuing economic recovery since the 2008 financial crisis, a recovery that has enabled large financial firms to rebuild their balance sheets.

{mosads}Despite the lack of any test of OLA, there is widespread belief that the process for resolving a large, troubled financial firm needs to be improved in cases where market forces were unable to save it from insolvency. 

In addition to reducing the risk of financial instability that could be caused by a large, troubled financial firm, the proposed improvements would strengthen protections against taxpayer bailouts of troubled firms.

Under present law, a large financial company, most likely with assets exceeding $50 billion, would become subject to OLA if the Federal Reserve’s Board of Governors recommended the appointment of the Federal Deposit Insurance Corporation (FDIC) as the receiver of a failing financial company. 

Depending on the principal activities of the company, the Fed’s recommendation must be seconded by the appropriate functional regulator — the FDIC, the Securities and Exchange Commission or in the case of an insurance company, by the director of the Federal Insurance Office.

The secretary of the Treasury, in consultation with the president, must then determine if the company should be placed into receivership. If the company’s board of directors does not consent to the receivership, the secretary must petition to the federal district court for the District of Columbia for appointment of a receiver.

If the court does not conclude within 24 hours that either the secretary’s petition is arbitrary or capricious, the FDIC will be appointed as receiver. That extremely short timeframe raises very serious due-process questions that the Treasury recommendations fail to address.

Key to the Treasury recommendations is enactment of a new Chapter 14 to the U.S. Bankruptcy Code. Under this chapter, a “bridge company,” or good bank, would be carved out of the troubled financial company. 

The bridge company would assume most of the company’s assets, certain liabilities and “the ownership interests of operating subsidiaries, allowing those entities to continue their operations and eliminating the incentive of their counterparties to run in a manner that would rapidly destroy value and create a contagion effect.” 

Hopefully this continuation of at least most of the company’s activities would minimize the risk of financial contagion endangering the entire financial system.

The Treasury report wisely recommends, though, that OLA’s tax exemption for bridge financial companies be repealed. Not only would continuation of such an exemption give a bridge company a competitive advantage, but it also would represent an indirect taxpayer subsidy of the resolution of a financial company under the Bankruptcy Code.

The remaining assets of the company as well as “predetermined obligations of the financial company” would be “left behind” in what essentially would be a bad bank. Those obligations would include all shareholder interests as well as holders of “capital structure debt,” essentially unsecured long-term debt that had been issued by the financial company.

Once the dust had settled, the “left behind” creditors and shareholders would become the owners of the bridge bank in a manner comparable to a successful reorganization of a company under Chapter 11 of the Bankruptcy Code.

Although not mentioned in the Treasury report, among the liabilities assumed by the bridge company would be the uninsured deposits of any bank transferred to the bridge company. That is, all depositors would be protected against any loss. 

As unlawful as that may sound, the FDIC has protected all depositors against any loss in 94 percent of all bank failures since the IndyMac failure in July 2008.

A key reason for resolving large, troubled financial companies under a new Chapter 14 would be to rely on a well-established, independent judicial system — the U.S. bankruptcy courts — as the forum for resolving issues that arise in any type of insolvency, notably the resolution of creditor claims and approval of any plan of reorganization.

A long-standing criticism of FDIC receiverships is the difficulty of challenging FDIC actions in the courts. As a practical matter, the FDIC board of directors has the final say on the actions of its own staff. That is hardly a recipe for fair treatment of creditor claims.

The Treasury report also “proposes eliminating the FDIC’s authority to treat similarly situated creditors differently on an ad hoc basis.”  There never was any justification for giving the FDIC such an arbitrary authority.

Treasury’s proposed reforms build on similar congressional initiatives, especially in the House’s Financial Services Committee. However, as is the case with other proposed financial regulatory reforms, it is unlikely that these laudable reforms to DFA’s OLA provisions will be enacted in the foreseeable future. 

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, the growing federalization of credit risk, and the false promises of cryptocurrencies.