Four Key Issues that Must Be Solved Before Next Big Failure

WASHINGTON — Two unanswered questions following the crisis are whether the government will allow the next major bank that faces insolvency to fail, and whether the broader financial system would survive such a failure.

In a recent speech, Federal Deposit Insurance Corp. Chairman Martin Gruenberg, whose agency was tasked by the Dodd-Frank Act with facing those questions head on, stopped short of declaring victory but emphasized how far the FDIC has come in setting up its new resolution regime. The agency has been continually building international relationships, urging needed flexibility on derivatives contracts and designing a resolution blueprint with options for how to keep "critical" subsidiaries operating during the failure of a parent.

"I would call that a pep-talk," Karen Shaw Petrou, managing partner of Federal Financial Analytics, said of Gruenberg's speech.

But there remain crucial operational issues to sort out before the government could clean up the failure of a massive firm without the risk of the resolution threatening the system.

"The conceptual framework is solid. They are now taking the steps to operationalize it," said James Wigand, a partner at Millstein & Co. who formerly ran the FDIC's complex resolutions division.

Dodd-Frank envisioned two strategies for unwinding a colossal firm. The first is banks must prepare themselves to be unwound through a traditional bankruptcy in a manner that prevents systemic effects. They must submit regular "living wills" to regulators to attest to their resolvability. But when a firm actually fails, and officials determine a bankruptcy would still be disastrous, the second strategy are special powers given to the FDIC to resolve the firm while taking steps to protect the broader economy.

To that end, the FDIC has discussed several options including where the agency closes the parent and transfers subsidiaries to a bridge entity with new management. However, the FDIC has stressed that it is not limited to that strategy. The agency could enter a subsidiary and wind down its operations, for example. To access capital in a resolution, shareholders would be wiped out while creditors could become equity holders. The agency says however the firm is resolved the component parts of the failed company would end up looking quite different than before.

But to ensure the plan works, regulators still have a lot to do, including wrapping up a key rulemaking requiring sufficient long-term debt levels at systemically important firms, and building on the FDIC's coordination with other countries to prepare for a cross-border failure.

Here is a portion of the to-do list:

Finalize Long-term Debt Rules

If the second option is going to work under the FDIC's resolution scenarios, the agency needs the firm to still have enough long-term debt — once its capital is exhausted — that can be converted into capital. Ideally, that would allow the failed company to absorb its own losses. The process is popularly known as a "bail-in."

But both domestic and international regulators still appear far from completing rules requiring sufficient debt levels. The Financial Stability Board, which proposed a global "total loss absorbing capacity" standard last year, has yet to finalize it. The board may wait until the next G-20 summit, in Turkey, in November. Meanwhile, the Fed has yet to even propose the U.S. version, and appears to be waiting for the FSB to make more headway.

Both the international and U.S. rules "are two remaining action items that must be completed to operationalize the framework," Wigand said.

He noted that it is not just TLAC requirements at the holding company level that are needed. The FSB proposed that material subsidiaries should hold minimum loss-absorbing capacity — known as "internal" TLAC — as a means of support.

"Conceptually, there's recognition that internal bail-in is a key part of this framework. But, it too needs to be operationalized," Wigand said. "Just like the external bail-in recapitalizes the holding company, the internal bail-in recapitalizes the critical operating subsidiaries."

Improve International Consistency

The FDIC has gone to great lengths to collaborate with the United Kingdom and other jurisdictions as they build their respective resolution regimes. The FDIC has signaled its belief that its work with the U.K., in particular, will breed cooperation between the two powers should a cross-border firm ever fail.

Gruenberg pointed to an October meeting of officials from the two countries that "furthered understanding among the principals in regard to key challenges to the successful resolution of U.S. and U.K." global systemically important financial institutions.

"The event built upon prior bilateral work between authorities in our two countries, which, since late 2012, has included the publication of a joint paper on G-SIFI resolution and participation in detailed simulation exercises among our respective staffs," he said.

But none of the agreements amount to the binding nature of a treaty, and when push comes to shove it can be difficult to predict how multiple jurisdictions will coordinate.

"I don't think there is going to be a treaty on this issue," said Simon Johnson, former chief economist at the International Monetary Fund and a professor at the Massachusetts Institute of Technology.

Johnson said one obstacle to the potential sale of Lehman Brothers to Barclays in 2008 — which would have averted the U.S. firm's eventual failure — was that the "Brits, frankly, did not want to take on a lot of risk in the transaction."

"There would be domestic pressures, no doubt, in the U.K. and other European countries," Johnson said. "People want to be cooperative, but once you're doing a cross-border resolution," regulators "are subject to very different pressures."

Meanwhile, Petrou said there are still clear differences between how countries like the U.K. and the U.S. view resolution issues and how they are viewed elsewhere. Banks in other countries, such as Japan, are more closely linked with sovereign governments, which may be less likely to let them fail.

"The U.S. focus on insolvency law, and not regulatory and government intervention, remains relatively unique," she said.

U.S. officials appear to be working on rules to address one area of global inconsistency: how easily counterparties terminate derivatives contracts in a failure.

When Lehman Brothers failed, counterparties exercised early termination rights, resulting in a disorderly bankruptcy and a fire-sale on underlying assets. Last year, 18 major global banks agreed to a protocol developed by the International Swaps and Derivatives Association to include temporary stays on termination rights, giving regulators time to conduct an orderly resolution.

But many say a more binding agreement is needed. The ISDA protocol only covers certain transactions, and while Dodd-Frank restricted termination rights for swaps subject to U.S. law, it is unclear whether a stay can be enforced in cross-border deals subject to the laws of another jurisdiction. Gruenberg said the Federal Reserve Board is expected to draft a rule "to codify compliance with the protocol."

"The ISDA agreement was a significant achievement, but there are still a lot of major financial parties that have not agreed that are not bound to that," Petrou said.

Approve the Biggest Banks' "Living Wills"

Since Dodd-Frank, attention has significantly grown on the law's requirement that banks, through their annual "living wills," prove to the FDIC and Federal Reserve Board that they could be unwound through a traditional bankruptcy.

But to date the 11 largest banks, which have been the focus of the living-will requirement, have failed to do that. The Fed and FDIC in August rejected their second-round drafts, saying they rely on rosy predictions and unrealistic outcomes. If the regulators find resubmitted plans this year still to be unacceptable, they have warned the banks could suffer formal consequences mandated by Dodd-Frank.

The living wills provision — included in Title I of Dodd-Frank — was meant to mitigate the need even for the FDIC to exercise its new resolution facility, which was mandated under Title II of the law. Gruenberg referred to the FDIC's new resolution powers as a "backstop" for when an orderly bankruptcy is unrealistic.

"Title II is a fallback, a failsafe," said Johnson, adding that the intent was to "make it so you would never have to use Title II.

"Using Title II itself would be a massive admission of failure on the part of the regulators and it would have repercussions for them politically," he said. "They should not want to go there."

But "the living wills have not made much progress," Johnson added. "We have not seen simplification or greater transparency ... into a failure would reverberate to the firm's counterparties. With Title II they have made a lot of progress. Title I: not so much."

Issue Rules on Employment Contracts

The FDIC's resolution framework is intended to allow the agency to part with the failed firm's executive team. Along with shareholders and creditors, Gruenberg said, "culpable management of the firm will be held accountable without cost to taxpayers."

But Wigand said an additional outstanding issue is how an executive's employment contract is structured while the firm is still operating. He said the FDIC needs to prevent firms from positioning such as contract at the subsidiary, which under the FDIC's framework could be more likely to get support.

"The employment contract for the CEO of the holding company should not be guaranteed by an operating subsidiary: it should fully reside at the holding company level," Wigand said. "Conversely, contracts for critical services should fully reside at the operating company level. Ensuring that contract placement is structurally appropriate could take the form of a rulemaking, but the supervisory or living-will review process may be better alternatives."