The future of the U.S. resolution regime: toward “a tale of two models”?
By Bora Yagiz, Compliance Complete
NEW YORK, Nov. 25 (Thomson Reuters Accelus) – The U.S. Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC) may be far from putting the final touches on titles I and II of the Dodd-Frank Act — the preparation of resolution plans within the framework of enhanced prudential standards, and the authority of FDIC to become the receiver of a failed non-bank financial or holding company and unwind it respectively. But comments by regulators and a conference in Washington last month held by the Federal Reserve Board and Federal Reserve Bank of Richmond on the topic reveal that some consensus is emerging on the structure and implementation of the resolution regime as well as its future course.
Resolution plans (also known as “living wills”) require all systemically important financial institutions (SIFI) to provide a detailed account of their ownership structure and contractual obligations, a list of their major counterparties, clarification on cross-guarantees tied to different securities, information as to whom their collateral is currently pledged, and an analysis of their resolution options under U.S. Bankruptcy Code.
The idea of FDIC receivership germinated after the politically charged ad-hoc bailout of financial firms such as Bear Sterns and AIG, and the costly bankruptcy of Lehman Brothers during the crisis of 2008. It is meant to replicate FDIC’s resolution authority to commercial banks (used in the last two decades following the savings and loan crisis debacle) and to extend it to SIFIs, albeit with significant modifications.
The FDIC receivership concept has to fulfill four criteria to function effectively. It must be initiated in a timely fashion, limit the damaging effect of financial distress on third parties (i.e. contain systemic risk), ensure that creditors and shareholders are not to be paid in full (to eradicate the moral hazard related to bailouts) and seek to preserve as much of the value of the company’s assets as possible.
Failure to provide effective resolution plans by firms could result in regulators imposing stricter capital, liquidity or leverage standards, or limitations on certain operations or activities. If warranted, regulators reserve the right to require divestiture of assets, though FDIC has made clear that it would have recourse to this only as a last resort.
The Resolution Regime rationale
The resolution regime has as its main goal the company’s orderly liquidation. This is in contrast to the rationale engrained in the bankruptcy code, which could allow a company to undergo total restructuring.
In the pre-crisis world, even if financial industry managers were allowed to run a company and propose reorganization plans under Chapter 11 bankruptcy, they would still be inclined to make the bankruptcy as undesirable and messy as possible so as to lure regulators into the more palatable option of receiving a bailout. Under Dodd Frank, bailouts are explicitly ruled out, institutions are required to prepare and update resolution plans on a yearly basis, and most importantly the management is discharged if their institution is brought under FDIC’s receivership.
Regulators have highlighted on many occasions, however, that the resolution mechanism is to be used only as the last resort, and that prevention of a SIFI failure is to be the preferable method.
Indeed, Fed Governor Tarullo stressed at a recent Fed conference on resolution that no matter how flexible and complete the mechanism is, a “more desirable outcome would be for its very credibility to work in concert with capital, liquidity, and other applicable regulations to reduce the chances of its actual utilization”.
Advantages and form of the resolution mechanism
The resolution regime has some clear advantages compared with the bankruptcy regime.
These are the speed of the process, avoidance of asset dumping into the market at low “fire-sale” prices possibly causing failure of related counterparties along the way, and skirting the cumbersome search for a buyer.
The resolution regime does away with a few important exemptions that exist under the bankruptcy code on “qualified financial contracts” (QFC) – certain type of derivative contracts. The bankruptcy regime does not subject the QFCs to the automatic stay rule, thereby allowing counterparties to close their positions immediately by selling the collateral. This could potentially put further strain on the institution under bankruptcy. Nor are the contracts covered under the bankruptcy’s preference and fraudulent provisions, which would require creditors to pay back any sale or purchase of the asset up to 90 days prior to bankruptcy if the transaction is deemed to have been done for less than its value.
The virtually unlimited funding available to the FDIC would also help it flex its regulatory muscle with more power. The regime allows the FDIC to borrow against the Treasury’s Orderly Liquidity Fund through the issuance of debt securities to the Treasury. It would then repay its debt out of the surplus funds that are judged to be greater than what creditors would receive under normal liquidation under the bankruptcy code. Should the initial collateral provided by the failed institution prove insufficient, the ex-post assessment that the FDIC would collect from other SIFIs would be used. There would, therefore, be no recourse to any taxpayer-backed capital injection to absorb losses.
A “single point of entry” (SPE) framework has been emerging as the favored approach of the regulators. In such an approach, the resolution takes place primarily at the level parent firm or holding company, in its home jurisdiction. The system is designed to mitigate risks and credibly impose losses on parent holding company shareholders and unsecured creditors, and enhance market discipline with the least amount of damage to the financial markets. It is also aimed at transferring sound operating subsidiaries to a new highly capitalized bridge entity.
The SPE contrasts with the admittedly costlier multiple point of entry (MPE) strategy, with different resolution regimes taking place at different levels, namely at subsidiary as well as holding firm levels (hence “multiple”) where coordination may be a problem as authorities could choose to act along their national or functional lines.
Grain of salt
Despite all the advantages of the resolution regime, it is yet shrouded by certain ambiguities.
The FDIC will not have the same set of unilateral and unfetters powers it can wield against commercial banks, and it may not move in as quickly. The resolution regime governed by a regulatory triumvirate can be put into motion (and place a covered financial company under FDIC receivership) only after the Secretary of the Treasury determines that an institution is in danger of default (after consultation with the president); and a two-thirds majority of both the Federal Reserve and the FDIC’s boards recommend its enforcement.
A delay in acting may prove especially costly in the absence of the Federal Reserve’s emergency powers that it utilized in the 2008 crisis. These powers were explicitly revoked by the Dodd Frank.
Even the helter-skelter Lehman bankruptcy proceedings have shown that most of the fears that the resolution regime intends to address failed to materialize. The priority financing Lehman was able to obtain during its bankruptcy allowed the firm valuable time to sell a significant portfolio of its assets at competitive prices, therefore limiting the harm to creditors. The dismembering and selling of the viable subsidiaries was also accomplished relatively swiftly without having to resort to a resolution mechanism. Along similar lines, the trade group International Swaps and Derivatives Association’s (ISDA) protocol for netting out derivatives trades has prevented the collapse of the bank’s counterparties.
In contrast to the bankruptcy proceedings, the resolution process offers minimum judiciary review, little transparency, and no negotiation between debtor and creditor to work out the outstanding debt.
Indeed, once decided, the institution has little scope to challenge regulators’ decision to step in. The U.S. District Court, to which the institution’s board may appeal, has only 24 hours to make a final decision on the case and can reject the regulators’ move only if it finds it to be “arbitrary and capricious.” It is hard to imagine a judge to risk having a role in what may be the next financial fall-out by invoking this clause.
Dodd-Frank stipulates that the FDIC should treat similar creditors in the same way, but the regulatory agency would also be in a position to disregard the “absolute priority rule” that respects the hierarchy of creditor status that exists under the bankruptcy code. It has the authority to pay certain creditors more by choosing to cherry-pick among liabilities. Challenging FDIC’s decisions would be difficult since they are typically made behind closed doors.
The success of the bail-in model of the SPE strategy, where debt is converted into equity of the new bridge entity, hinges on the debt conversion into equity at the parent level for the new bridge company. Given the current absence of rulemaking on long-term debt requirement and regulators’ skepticism on the issuance of contingent convertible debt securities, however, ensuring the availability of sufficient amount of debt may be difficult.
The one-day stay on the close-out of QFCs also remains incomplete and does not extend to contracts governed by non-U.S. law with non-U.S. counterparties, as noted by New York Federal Reserve Bank President William C. Dudley at the resolution conference. Foreign counterparties could find it to the best of their interest to exercise their right to close out their derivatives positions upon the placement of the failed parent company into receivership.
Along the same lines, and perhaps on a broader level, is the cross-border cooperation among regulators. Even though the FDIC has been closely working with its counterparts in the U.K., Germany and Switzerland (covering the majority of the operations of 26 of the 27 international SIFIs) in streamlining the process, uncertainty remains as to how each national regulator will react when push comes to shove. At the very least, a unilateral ring-fencing by any regulatory counterpart could seriously hamper the SPE strategy.
Given the shortcomings and complexities of the resolution mechanism, many have advocated making alterations to Chapter 14 of the bankruptcy code rather than resorting to Title II. The Hoover Institution’s Resolutions Project is perhaps the most notable proposition to date. In fact, the project openly proposes to discard the resolution mechanism altogether.
The Project envisages the management of the new bridge entity by a private trustee (rather than by FDIC) and the repayment of the claimants in order of their priority under the bankruptcy law. Its plan of keeping operating subsidiaries out of bankruptcy is also intended to reduce the need to rely on cross-border cooperation. By offering to subordinate the long-term debt held at the parent level to short-term debt held at the operating subsidiary level, it also aims to curtail a possible short-term creditors run.
The project also has its shortcomings. The private funding it seeks to obtain may simply not be available during an extreme economic crisis. The absence of Federal Reserve’s emergency powers and the limited use of discount window by non-bank affiliates may also stifle the liquidation process, increasing the chances of a systemic risk.
A tale of two models
Given that each has its distinctive advantages, the regulators may choose to have a two-model framework. Said Fed Governor Daniel Tarullo, “the best outcome may be an amended Bankruptcy Code co-existing with Title II, with the former the default route in the case of a large financial firm’s insolvency, and the latter available for the unusual moment when systemic risks loom large.”
The still-evolving resolution mechanism, then, may not replace but rather complement an overarching bankruptcy code.
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)