Did Dodd-Frank Resolve the 'Too Big to Fail' Issue or Give It New Life?

WASHINGTON — One of the chief goals of the Dodd-Frank Act was to end the notion of "too big to fail," but months after the law's enactment, a debate persists over whether that goal will be met.

Perhaps no section of the law is more critical to that discussion than the Federal Deposit Insurance Corp.'s power to unwind failing giants.

Supporters argue such power ensures the government can fail a large, systemically important company without causing stress to the financial markets. But critics charge such authority will do the opposite, and instead give the government flexibility to bail people out.

"It's going to be … difficult for the FDIC to convince people" that the resolution authority "will work without having a real, live example of it working," said Heath Tarbert, a senior counsel at Weil, Gotshal & Manges LLP and a former counsel to the Senate Banking Committee.

Until then, questions over the government's new powers are academic. Will it actually use those powers to close a company? Will the FDIC really be able to prevent systemic fallout?

For now, the FDIC's immediate challenge is to create rules that can help persuade skeptics the era of big bailouts is over.

"I know 'too big to fail' became ingrained in the architecture, and is built into everyone's thinking," FDIC Chairman Sheila Bair said in an interview. "Dislodging that is going to be difficult. We're quite determined."

The FDIC is expected early next year to propose comprehensive rules laying out how such an unwinding would take place. A precursor came in October with a narrower proposal clarifying which creditors of failed institutions could get government relief beyond what other creditors receive.

At the time, the agency warned that it planned to be stingy, providing extra coverage only for creditors that provide a firm's essential services that are needed during the course of a receivership. Officials also said a number of times that all creditors in a seizure should expect losses.

Observers said the agency could issue a broader rule that further undermines market expectations of a government backstop.

"If the FDIC constructs a meaningful, credible plan for resolving some of these really large institutions — particularly in the nondepository side, where the FDIC historically has not had expertise — that would be a credible threat" to the market, said David Min, associate director of financial markets policy at the Center for American Progress. "To have that credible threat would be important."

But it is still hard to find anyone who believes that the resolution authority signals the end of "too big to fail."

"It does not stop 'too big to fail,' and it's not possible to stop 'too big to fail,' " said Bradley Sabel, a partner at Shearman & Sterling LLP and a former official at the Federal Reserve Bank of New York.

"Almost by definition," Sabel said, "the entities that are too big to fail have international operations. … If any significant amount of assets or funding or both is in those operations, it is either very difficult or simply not possible for the FDIC to automatically take possession of them in either a liquidation or sale."

At the height of the crisis, policymakers saw a gaping hole in the fact there was no government mechanism — as there was for resolving a failed bank — for closing a systemically important nonbank such as a holding company or a brokerage firm.

The lack of a wind-down mechanism was blamed in large part for the government's scrambling when Bear Stearns Cos. fell apart; for the unprecedented bailouts of Bank of America Corp., Citigroup Inc., American International Group and others; and for the chaos that followed Lehman Brothers' bankruptcy.

Much of the debate surrounding Dodd-Frank envisioned a new mechanism by which regulators could exempt a systemically important firm from bankruptcy, and appoint the FDIC as its receiver with the mission of preventing a wider meltdown. The FDIC and others supported having giant firms pay assessments into a $50 billion fund that would support the new resolutions.

But for opponents of the bill, especially in the Senate, the new resolution capability, particularly the fund, was viewed as a recipe for more bailouts. Some opponents instead supported reforming the bankruptcy process as a means to contain the systemic impact of a failure. They wanted no flexibility.

When "you put the honey pot out there, sometimes it's going to be used in unintended ways," Sen. Richard Shelby, R-Ala., the top Republican on the Banking Committee, said in March.

Although proponents of the provision contended that the fund was an operational tool to support the FDIC's management of a receivership, it was eventually taken out under a compromise between Shelby and Connecticut Democrat Chris Dodd, the panel's chairman. Their agreement included other restrictions on the government's ability to award bailouts.

Under the new law, the administration, with concurrence from regulators, decides whether a large firm should be resolved through the FDIC mechanism, rather than through bankruptcy, to prevent the failure from affecting other companies.

Dodd-Frank also expressly prohibited bailout funds from going to individual institutions. Aid can be disbursed only in emergency situations in a more systemwide manner, through the Federal Reserve Board's so-called 13(3) authority, and a broad-based debt guarantee from the FDIC.

The FDIC is also charged along with the Fed with requiring large firms to produce "living wills," hypothetical resolution plans to guide regulators through a company's structure and help ease its wind-down.

Under Dodd-Frank, if the agencies are not satisfied with a firm's specific plan, they can force it to divest certain assets. The process suggests regulators will be interested in forcing companies to develop ways to help unwind them more easily, or in reducing their overall risk to the system.

For individual resolutions, the FDIC must borrow funds from the Treasury Department to support its operational costs, and pay back the loan from sales of a failed company's assets. If such sales are insufficient, the agency must then "clawback" funds it awarded to certain creditors. Only after the clawback is insufficient can the FDIC charge other firms an assessment.

Bair said she was pleased with the final result.

"It doesn't surprise me that there was a lot of scrutiny and maneuvering on who wanted to do bailouts and who didn't want to do bailouts," she said. "I take a lot of pride in the fact that the language … was passed in the Senate with an overwhelming bipartisan consensus."

But the battle over implementing the policy has just begun.

For many, the perception that the government could still give a systemically important firm a lifeboat, rather than a coffin, remains. To be sure, the law lays out a different scenario.

But observers said that the recent crisis proved policymakers can be spooked into taking dramatic steps to save the system, such as acting without a clear legal mandate or urging Congress to deliver that mandate under duress.

"You can never eliminate the possibility of a bailout. Congress can always come in and say, 'There's an emergency and we're going to deviate from whatever the existing rules are,' " said Kenneth Scott, a former attorney and regulator who is now an emeritus professor at Stanford Law School.

Yet Scott and others said the implementation of the resolution policy could avert such an emergency, or at least make it less costly.

"What you would like to see is a system that makes the likelihood and magnitudes of those disasters smaller by really convincing all the other market participants that they are indeed at risk, and in a manner where they can see the risk spelled out in relatively firm terms so they don't think they can manipulate it," he said.

The FDIC could at least put a dent in the "too big to fail" perception with further statements about the risk that market participants face.

"If the FDIC wanted at least to raise the odds in the public's mind that 'too big to fail' is over, they could issue a clarifying statement — it doesn't even have to be a rule — that would indicate how the haircuts are going to work for creditors. It would make it very clear that all uninsured creditors are at risk and reiterate that the haircuts are going to be applied according to seniority," said Robert Litan, a senior fellow at the Brookings Institution and research chief at the Kauffman Foundation. "There's an old adage that says you can't repeat policy enough. It doesn't hurt to say it over and over again: 'There are going to be haircuts.' "

Bair said the combination of several Dodd-Frank reforms, including the resolutions policy, "should send a signal to the market that we are very serious."

She said communication, in addition to regulatory policy, is important.

"The whole point of this is to get market discipline back into the decision-making about whether to invest in these very large entities and fuel their growth," Bair said. "Regulation can't do it all alone, far from it. A lot of it is about messaging and the market and building into their pricing the understanding that these institutions are not going to be bailed out going forward."

But others said the policy discussion following the 2008 crisis may not necessarily reflect what regulators will do when faced with an emergency situation.

"Hopefully, we'll never have to think about it again. But by the same token, if you have a situation of the magnitude of the last two or three years, it's hard to say whether or not the government won't do what has to be done to stabilize the economy," said V. Gerard Comizio, a partner at Paul Hastings.

"I don't think the premise is 'bailouts as usual,' " Comizio continued. "But you should never say never."

Ultimately, after the ratification of a plan to let the government unwind giant firms, it may just take one example of walking the walk before the public believes the resolution plan is a reality.

"As a practical matter, people will not assume that it will happen until they actually see it happen, and then the markets will react," said Ralph "Chip" MacDonald, a lawyer at Jones Day in Atlanta.