Gruenberg Confronts Doubts That FDIC Will End TBTF

CHICAGO — The Federal Deposit Insurance Corp. on Thursday stepped up its campaign to convince Wall Street and Washington that it has the political will to take down a large, failing banking company a day after a senior agency official cast doubt on the idea.

In a speech at the Federal Reserve Bank of Chicago's regulatory conference, Acting FDIC Chairman Martin Gruenberg presented a largely wonky discussion that was heavy on details of a potential resolution of a systemically important firm, including how a firm's subsidiaries would be handled.

But the overarching point of the speech was to reinforce that the FDIC is serious about developing — and using — its new liquidation authority.

"The burden is on us both to explain what we're doing and do it in a way that appears credible and realistic," Gruenberg told American Banker in an interview after the speech. "On the one hand, you don't assume financial markets will automatically accept the credibility of what we're saying. On the other hand, we don't assume that they won't be attentive and listen to what we have to say and we think there's a possibility that if we could explain ourselves well… it'll actually be a realistic way to manage an orderly resolution."

But the FDIC is not just fighting a perception from those outside the agency anymore, a stark reminder that its argument remains a tough sell.

Tom Hoenig, one of the FDIC's newest board members and the nominee to serve as its vice chairman, raised fears at a Congressional hearing this week that while regulators now have the tools to fail a large firm, they may ultimately shirk that decision.

"Dodd-Frank does give us the mechanism to do that," Hoenig told a Senate subcommittee on Wednesday. "It's whether we have the will going forward. Now we have even larger institutions accumulating greater risk in concentration. So the will part will be even more difficult to come forward."

Ironically, Gruenberg's remarks came the same day that the House approved an appropriations bill that included a provision to eliminate the FDIC's ability to resolve a large banking company. That provision is not expected to be approved by the Senate but underscores the remaining controversy around the FDIC's new powers, which many Republicans claim is inferior to the existing bankruptcy process.

Industry observers were divided on whether Gruenberg succeeded in his mission. Jaret Seiberg, a senior policy analyst for Guggenheim Securities' Washington Research Group, said the market believes that the FDIC would fail a large banking company in a one-off situation. What it does not accept is that the agency would act the same way in a crisis.

"When everything is going to hell in a handbasket, the assumption is that the government is going to intervene and prevent a deep recession from becoming a Great Depression," Seiberg said in an interview. "The market's perspective is they are not going to let allow the big banks to fail."

He was seconded by Cornelius Hurley, director of the Center for Finance, Law & Policy at Boston University, who said "the markets are convinced that in the next crisis the TBTFs will be bailed out just as they were in the last one."

"The FDIC can put as much foam on the runway as Dodd-Frank allows but in the next crisis, it will be a bailout, not resolution plans, that keeps a TBTF from crashing and taking the economy down with it," Hurley said.

But Gruenberg dismissed the suggestion that the FDIC wouldn't act in a crisis to fail several banks at once, saying "if we had to handle more than one, we could do it."

He argued that Dodd-Frank didn't just give the FDIC resolution powers, it also reoriented the banking regulators to focus earlier on systemic problems before they worsen.

"Optimally, we would avoid resolution altogether," he said.

Mitchell Glassman, the FDIC's former director of resolutions and receiverships, said that many of the details in Gruenberg's speech weren't new, but noted it was an attempt to show the FDIC's progress in order to bolster the agency's credibility.

"He's putting a little more granularity here to let the market know — yes, the FDIC is going to be ready to handle this situation," said Glassman, who is now a director at Deloitte Consulting LLP. "What he's reinforcing is that the FDIC has basically been working on this issue since day one and they are taking this mission seriously."

For his part, Glassman said he believed the FDIC would act if necessary.

"They will always rise to the top and do their mission," he said. "That's the focus of their people and their culture. I think the FDIC will follow that pattern."

In the interview, Gruenberg said the resolution process has to be well understood and well-publicized to ensure it can be used effectively.

"It's important to establish market expectations as to what may occur in the event of a failure of a systemic company," he said. "It's important from our standpoint to communicate to the financial markets what to expect, what the approach is going to be, because we think that's going to be important in terms financial market reaction if we're dealing with systemically important financial institution."

Randall Kroszner, a former Fed governor and now a professor at the University of Chicago Booth School of Business, agreed it was "very important for the FDIC to provide clarity about how the resolution process will work."

In an interview, Kroszner said that one of the key problems during the financial crisis was uncertainty about how various claimholders would be treated if a firm was failing.

"Without providing a clear and systematic framework so that the markets can understand how different claimholders would be treated when the new resolution authority is exercised, we will not have addressed this source of fragility," he said. "I applaud the FDIC for taking the initial step in what I'm sure will be a lengthy dialogue on this important source of financial fragility."

Gruenberg's speech largely collated FDIC officials' statements over the past two years since the Dodd-Frank Act was enacted. The agency released a study last year detailing how it would have handled the collapse of Lehman Brothers in 2008 had its Dodd-Frank powers been in place then. Many of those suggestions mirrored what Gruenberg said on Thursday.

The FDIC chief said that the agency would likely act first by seizing the holding company and turning it into a bridge holding company — a practice the agency has used in bank failures, notably the collapse of IndyMac. Such a decision allows the subsidiaries of the holding company to remain open, Gruenberg said.

"This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings," Gruenberg said in the speech. "Because these subsidiaries will remain open and operating as going-concern counterparties, we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal. In short, we believe that this resolution strategy will preserve the franchise value of the firm and mitigate systemic consequences. This responds to the goal of financial stability."

To create the capital base of the bridge firm, some of the debt of the former parent company, which will be left behind in a receivership, will be converted to equity.

"To do this, the FDIC will estimate the extent of losses in the receivership and apportion these losses to the firm's equity and subordinated and unsecured debt holders according to their order of priority," Gruenberg said. "In all likelihood, the firm's equity holders will be wiped out and their claims will likely have little or no value."

To capitalize the new company, the FDIC is likely to look to subordinated debt or even senior unsecured debt claims, Gruenberg said.