How FDIC's Big Bank Failure Regime Turned a Corner in 2013

WASHINGTON — Call it the Tinker Bell test.

The Federal Deposit Insurance Corp. made significant progress in 2013 developing a strategy to close and unwind financial behemoths, including enhancing staff, engaging with international regulators, reviewing banks' internal resolution plans and detailing its "single point of entry" strategy.

But the success or failure of the agency's new resolution plan and its ability to end the perception of "too big to fail" turn on something more abstract: whether market participants believe in it.

If companies' bond and share prices reflect "the intrinsic credit risk of a company and not an expectation of a bailout, then the FDIC will have effectively implemented" its orderly liquidation authority, said Michael Krimminger, a former general counsel at the agency and now a partner at Cleary Gottlieb Steen & Hamilton LLP. "That requires market participants to conclude that OLA is practical and will be used in any future crisis."

The agency is closer to earning that credibility than it was over three years ago when Title II of the Dodd-Frank Act established its powers to unwind failed systemically important financial institutions.

In November, Moody's said it was removing the ratings "lift" for eight of the largest banking firms that stemmed from assumptions of government support. Moody's said the FDIC's "substantive progress" reduces the likelihood of that support.

But a December report by Standard & Poor's came to a different conclusion, saying resolution procedures were still a "work in progress" and it was preserving the ratings lift. S&P said it may start to remove that advantage at a later point if a resolution regime in any one of the key jurisdictions where SIFIs operate proves more credible.

Richard Herring, a professor at the University of Pennsylvania's Wharton School, said the FDIC's single-point-of-entry plan, in which losses imposed on a failed parent's shareholders and creditors are meant to keep subsidiaries operating and avoid taxpayer losses, is a "clever" approach to solving hurdles associated with resolving a giant firm. But he said complete faith in the system may only come after it is tested.

"The sad truth is the regulators lost so much credibility in 2008 and 2009 doing all sorts of things they said they would never do that simply saying they're going to do something still demands some way for the outside world to believe that things will be different next time," said Herring, who sits on a committee that advises the FDIC about systemic resolutions.

A Dec. 10 paper detailing the agency's strategy is likely to help guide future work on the platform. It described a process for closing the holding company, wiping out shareholders and forcing losses on creditors. Some subsidiaries could be closed too, but the basic idea is to keep subsidiaries open under a bridge firm, funded by the parent's losses and, if needed, Treasury Department loans that would be repaid either from assets of the failed company or industry assessments. After restructuring the old firm's organs, the receivership would eventually create a new firm in which the old creditors could own equity.

"The FDIC has made major progress in developing a viable resolution strategy for institutions previously considered 'too big to fail,'" said Sheila Bair, the agency's former chairman who is now senior adviser at The Pew Charitable Trusts. "We are not dealing in platitudes and sound bites. This is serious, methodical work by professional FDIC resolution specialists to make sure taxpayers are never again put at risk from a big bank failure."

Still, the FDIC acknowledges concerns have been raised about the strategy. Following its release, members of its advisory committee, including former Fed Chairman Paul Volcker, suggested the result of a single point of entry resolution — a new firm consisting of remnants of the failed company — could be perceived as similar to a bailout.

The document, meanwhile, included various questions for public comment, including whether the subsidiaries have an unfair advantage from their backing in the resolution and about risks of international regulators "ring-fencing" — or seizing for the benefit of their citizens — the operations of a failed U.S. firm that are on foreign soil.

"We identified both of those as issues that we wanted comment on. We recognized that these are issues that have been identified in the process," Arthur Murton, a longtime FDIC official who was put in charge of the resolution facility in July, said in an interview.

Murton reiterated that the strategy is not to create a new firm that carries on the legacy of the old one.

"We expect that if we were to do a Title II resolution, that the entity or entities that come out of that resolution would look very different from the entity that went into the resolution," he said.

In the paper, he added, "we try to say pretty clearly that what comes out of this will be one or more entities that could be resolved under the bankruptcy code. If that means selling off parts, shrinking it or restructuring it, that's what we would do."

He said the FDIC is seeking to be "as transparent as possible as we develop this strategy.

"This document is a real step forward in doing that. It consolidates the progress that we've made in developing single point of entry. We'll get feedback from the public and market participants and we'll take that feedback into account as we further develop the strategy."

Krimminger, who called the document a "helpful and positive step forward," said how the FDIC addresses questions that have emerged about the process will further influence the market's perception of the new platform.

"The FDIC identified many issues that need clarification for market participants to have a better understanding of how the resolution process will actually work," he said. "The reason those clarifications are important is that OLA will only really work if it influences the pricing for debt and equity long before any resolution by the FDIC."

The single-point-of-entry platform, meanwhile, has appeared to gain steam internationally. In late 2012, the FDIC and United Kingdom expressed joint support for the model. The U.S. also got a boost when then-deputy governor of the Bank of England, Paul Tucker, signaled the U.K. would give the FDIC free rein to resolve U.S. firms that have London operations.

Over the past year, the FDIC has conducted discussions on cross-border planning with other jurisdictions including Switzerland, Germany, Japan, China and the European Commission. Agency officials have also participated in resolution planning exercises organized by the Financial Stability Board. The FDIC along with U.K., Swiss and German authorities also jointly called for changes in derivatives contracts to limit contract termination rights in a SIFI failure.

"The FDIC is building relationships with these foreign authorities that simply did not exist before the crisis," Murton said. "We will know the people who we will have to deal with in a cross-border resolution. We will understand what their concerns are and how their system works, and they will understand our system as well. It won't all be new."

He added that engagements with foreign regulators increase the chance other countries will have faith in the FDIC's approach if the single point of entry strategy had to be executed, rather than get in the way of that strategy.

"By building these relationships with these jurisdictions, and demonstrating that we have a credible approach that could work and avoid disruption, we think we are making it more likely that they would allow our resolution process to proceed as we've described it," he said.

The FDIC and Federal Reserve Board also continued to receive so-called "living wills" from large firms, in which a company plots its own failure scenario under a traditional bankruptcy. Companies are on a staggered schedule for filing the wills, based on their size. After the largest firms submitted first drafts in 2012, the second wave of companies filed in July 2013. The third wave was due in December. In April, agencies revised instructions for the second drafts required of the largest firms, which were submitted in October. Under Dodd-Frank, regulators can force companies to make structural changes if their plans reveal impediments to an effective resolution, and officials are said to be eying the second versions more critically than the first.

Currently, firms disclose a very top-level summary of their resolution strategy to the market. But some observers said the two agencies should require more information about the living will process to be revealed publicly.

"One of the things they could do is show us how they are actually simplifying the structure of banks so that the market believes they could be resolved and so that the securities markets have a good sense of what is at risk and why," Herring said.

Meanwhile, the Fed is also working on a rule setting a minimum level of long term debt held at the bank holding company level, which is meant to ensure the FDIC can access enough liquidity to fund a bridge operation should the company fail.

The Fed's long-term debt rule will "establish greater confidence that the SPOE approach will work," said Jim Wigand, who preceded Murton as head of the FDIC's Office of Complex Financial Institutions before he retired from the agency. "Additionally, a rulemaking on who can hold the default risk associated with those instruments, intracompany bail-in-able instruments, and contract guarantees would be helpful."

Observers also said the FDIC will likely seek to carry its international engagements further.

"The FDIC needs to continue to engage in detailed discussions with foreign regulators building on and deepening their dialogue with the Bank of England," Krimminger said. "We do not have an international treaty or any international law governing a cross border resolution and it will take a long time before that can be discussed realistically. But OLA and the single point of entry strategy provides a framework to begin those discussions because it is a strategy that is built on the incentives that drive what foreign regulators will do in a crisis."