Why did regulators ignore Dodd-Frank and orderly liquidation for failed banks?

At 6:15 pm eastern time on Sunday, Treasury Secretary Yellen, Fed chair Jerome Powell and FDIC chair Martin Gruenberg issued a statement confirming that the FDIC insurance fund would cover all depositor balances in accounts held at the failed institutions Silicon Valley Bank (SVB) and Signature Bank, even those above the $250,000 FDIC insurance limit. 

The statement said that the agency heads were taking the extraordinary action of guaranteeing all deposits in two specific banks using powers available to them under a “systemic risk exception” even though the Dodd-Frank Act specified that the Treasury, FDIC, and Fed should use Orderly Liquidation Authority (OLA) in such a situation. 

Banks and Congress should be asking why the administration’s financial regulators did not use OLA.

The government officials’ statement reads in part:

“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the president, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.

We are also announcing a similar systemic risk exception for Signature Bank, New York, New York, which was closed today by its state chartering authority. All depositors of this institution will be made whole. As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.”

While tapping the deposit insurance fund to ensure all SVB and Signature Bank depositors may not look like a taxpayer bailout, all banks pay FDIC insurance premiums. This insurance cost is indirectly passed on to bank depositors who are taxpayers. Score this bailout as you like.

The odd thing about this rescue is that the Dodd-Frank Act prescribed an entirely different method for resolving a failing systemically important bank without using taxpayer funds. The Dodd-Frank solution is to protect the failing bank’s depositors by taking over the failing bank’s parent holding company using a special resolution power called OLA.

OLA permits the FDIC to seize the resources of the failing bank’s parent holding company and use them to support the failing bank’s operations. OLA empowers the FDIC to keep the failing bank open and operating without any depositor losses and ideally without the use of any deposit insurance funds.

The FDIC has developed and publicly published its plan for exercising OLA. The plan is called the Single Point of Entry resolution strategy or SPOE.

In an SPOE resolution, the FDIC is appointed receiver of the failing bank’s top holding company. The FDIC charters a bridge institution and transfers all holding company assets and secured liabilities to the bridge, including the company’s equity position in all subsidiaries including those in the failing bank. The bridge functions as the new parent holding company, and the FDIC will appoint new management to operate the bridge and its subsidiaries. 

The FDIC will leave the shareholders of the failed bank’s parent holding company and most of the failed parent’s unsecured liabilities in the receivership. These claims will be converted into receivership certificates, so the bridge will have little debt when it is first formed. This transaction expropriates the value of shareholder and unsecured creditor positions in the parent holding company and creates a bridge that can easily borrow and downstream funds to support the operations of the failing bank and any subsidiaries transferred to the bridge. Once the bridge is established and operating, the FDIC will seek a purchaser of the entire bridge or sell off stabilized bridge subsidiaries.

OLA removes the parent holding company’s limited liability protection and forces holding company investors to absorb losses that exceed their equity investment in the failing bank. When the secretary of the Treasury invokes OLA, it triggers a change in parent company investor property rights in a way that will protect the failing bank and other subsidiaries from loss or require them to engage in asset “fire sales” to meet depositor liquidity demands.

SVB has a holding company, SVB Capital, that is still open and operating. It has a market capitalization recently reported to be over $2.3 billion and long-term debt of about $5.4 billion — balances that potentially could be utilized to support depositors in the failing SVB bank. SVB Capital’s annual report suggests that it owns several businesses besides SVB, and these businesses apparently still have significant value given reports that JPMorgan is interested in purchasing SBV Capital.

Banks will be required to pay additional deposit insurance premiums to cover SVB and Signature Bank losses. They have a right to know why the secretary of the Treasury, Federal Reserve Board and the FDIC did not use Dodd-Frank OLA to resolve SVB. That SVB’s holding company is still operating and worth perhaps billions suggests that OLA could have been used to save deposit insurance fund losses and the additional insurance premiums banks will face.

The administration should explain to Congress why a blanket FDIC insurance guarantee that mitigated losses for SVB Capital shareholders and bondholders was the cheapest resolution approach for the FDIC deposit insurance fund even though it will impose new insurance costs on banks and ultimately on their depositors. There needs to be a mechanism to hold an administration’s financial regulators accountable for actions they take when they invoke an emergency systemic risk exception.

Paul Kupiec is a senior fellow at the American Enterprise Institute specializing in financial services issues.