FDIC Preps Plan to Flesh Out Big Bank Resolution Process

The Federal Deposit Insurance Corp. knows it must put some meat on the bones of its process for dismantling large financial firms, but is struggling to strike the right balance between providing too much detail and not enough.

"One issue is flexibility versus certainty," says Jim Wigand, who heads the FDIC's Office of Complex Financial Institutions. "But there is also the tension of providing enough information so that the marketplace and stakeholders know what to expect versus getting too granular, providing too much information and not in the right area."

In an interview last week, Wigand says the agency has narrowed its focus to a handful of issues and will propose a policy statement by yearend. He expects a final version within three or four months of proposal. (Assuming the agency waits until yearend — though Wigand emphasized it could come earlier — a final statement would be in place by April 30.)

The FDIC arguably got the biggest job doled out by the Dodd-Frank Act: resolving systemically important financial companies that fail.

The orderly liquidation process is mandated by the 2010 reform law, and a year ago the FDIC sketched its approach by unveiling its "single point of entry" plan.

It envisions the government seizing a failed giant at the holding company level and continuing to operate its subsidiaries. Shareholders would be wiped out, management would be replaced and a plan for resolving the company would be created and executed by a bridge company.

Wigand was unequivocal when asked if a company leaving the Orderly Liquidation Authority process would resemble the one that entered.

"The answer to that is a definite no," he says. "This company has to be nonsystemic as it exits the overall process."

Assets may be sold, whole lines of business may be spun off, but the company will be smaller and simpler when the FDIC is finished. The process may take longer than the six months that the FDIC anticipates running any bridge company, so Wigand says the FDIC could continue to influence the company's operations through a supervisory agreement.

"It needs to be done 'orderly,' and that means months, if not years, and that will be built into this process."

The FDIC was widely praised for both its creativity and practicality in coming up with single point of entry. But like any big idea, plenty of details remained unanswered. The agency promised to clarify via a policy statement exactly how a resolution would work in practice.

But the FDIC missed its self-imposed yearend 2012 deadline, and the delay is undermining the agency's credibility. (Wigand disagrees, saying "being thoughtful is better than rushing through the process.")

Wigand blames the delay on two key factors: the job is harder than the FDIC expected and it has had to coordinate with outsiders, including other regulators and people in the market.

"We have a list of all of these tasks that we need to address associated with implementing OLA and that list is huge," Wigand says. "But what we've done is culled it down to the key tasks that we believe need to be addressed in this particular policy statement."

Perhaps the biggest task on that list is how the failed firm will be recapitalized.

The way it's set up, OLA can't work unless these giant companies have enough long-term debt at the holding company level. It is that debt that will be converted into equity of the bridge company.

"This is a structural subordination," Wigand says in describing a potential OLA. "This company operates from the top. It is the shareholders of that top company that elected the board, it is basically the investors, those bond purchasers, that have lent money up at the top."

Because the largest firms use such complex structures, the FDIC had no choice but to go in at the holding company level. As Wigand put it, these firms are "so interconnected at the operating company level that you can't allow one of those op-cos to fail independently without blowing the whole thing up.

"So if that is the choice of how this company operates, as a single enterprise, then that's the way it's going to fail. It's going to fail from the top down. It's going to be the holding company that fails first, and only in the event that there is an insufficient amount of bail-in debt at the top, then you go to your next level."

I asked Wigand if that is his way of saying people can stop worrying about haircuts on short-term creditors or derivatives contracts. His answer? Probably.

"The long-term debt at the top will effectively be providing support to those operating companies."

But that is only true if there is enough holding company debt.

"That's the one point that we can't forget," Wigand says.

"If there is an insufficient amount of bail-in debt at the holding company level, then an operating company will need to go into resolution. Because at the end of the day, the creditors of the firm are going to have to bear the cost of its resolution."

Unfortunately for the FDIC, it doesn't regulate holding companies. The Federal Reserve Board does, and while several senior Fed officials have said writing a rule on long-term debit is a priority, they have not said when it will be proposed.

Wigand was very careful not to trespass on the Fed's turf, refusing to answer any detailed questions. But he said the FDIC was consulting with the central bank and laid out the questions regulators are mulling.

"There are more moving pieces to it than one might assume," he says: "the amount of debt, the seniority composition, which firms must issue it, who can hold the debt or its credit risk, the duration of the debt instruments, laddering requirements, the basis for calculating the amount, how it relates to equity capital, and how it relates to intracompany bail-in-able debt or other holding company assets."

Wigand is optimistic that another Dodd-Frank creation — living wills that require the largest companies to explain how they could be unwound in a failure — will enhance the OLA process.

"I think the living-will process will result in changes, but those changes will be very company-specific," he says. "I think the companies, after looking at how they operate from their first round of submissions, are already making changes to make themselves somewhat simpler."

Pressure from investors and regulators, he adds, will force "these companies to have a higher degree of transparency."

Wigand says the policy statement also will explain how the Orderly Liquidation Fund, another Dodd-Frank mandate, will work.

Dodd-Frank bars the FDIC from spending any taxpayer money on one of these resolutions. All costs must be covered by the liquidation, and if asset sales fall short, then the FDIC must assess a fee on all the other systemically important companies.

Wigand doesn't think it'll ever come to that; he figures the bridge company will be able to go to the capital markets for liquidity. And he thinks markets will respond because they know the FDIC has the power to step in and force other SIFIs to provide liquidity.

"The OLF is a backstop. We're hoping that the well-capitalized bridge company will be able to access customary resources that are available to financial companies for liquidity almost immediately," he says. "With the market knowing that there is a backup source of liquidity, there will be a greater degree of comfort to do business with the bridge and that becomes self-fulfilling. Our expectation is that the bridge won't need to tap" the OLF.

Cross-border coordination is another daunting task for Wigand.

The FDIC has already made a lot of progress with the Bank of England and is talking with the Europeans, the Swiss and the Japanese. "The amount of discussion is substantially different today than what existed even three or four years ago," Wigand says.

But he admits that it's impossible to bind future policymakers.

"I am being very candid about this. … Nobody can commit for somebody in the future," he says. "But what we can do is have lots of discussions at the staff level that establish working relationships so we better understand each other."