To End Big-Bank Subsidies, Fix the FDIC’s ‘Off' Switch

The unanimous Senate vote last year mandating a Government Accountability Office study of the subsidy allegedly enjoyed by the largest banks sent the clearest possible signal that both sides of the aisle think the "too big to fail" problem is as bad as ever. 

So far, much industry attention has focused not on this subsidy, but rather on one response to it – the Brown-Vitter legislation. The bill raises many important questions, but the "subsidy" premise lies not just at its root, but also as the base rationale for many regulatory actions far more likely to happen first. 

Is there a big-bank subsidy? No, at least not along the $14 billion to $83 billion lines Bloomberg News recently calculated: But, the answer will be yes – big banks are still TBTF – if regulators do not quickly build the infrastructure needed for Dodd-Frank's no-bailout liquidation regime to protect taxpayers. This is hard to do, but three years after Dodd-Frank was enacted the orderly liquidation authority is still on the drawing board, leaving many to wonder if it can ever be made to work.

If OLA is irreparably flawed, then a subsidy exists even if it's hard to calculate; if OLA works, then any subsidy now will disappear later in favor of real market discipline forcing true structural reform. The key question thus rests on uncertainty – we won't know if TBTF is erased until we know if OLA works and we won't know this dispositively unless or until there's a crisis. Is there a way now to assess the subsidy even in the face of this considerable uncertainty?

Yes. A first-order priority is research on the various policy factors that differentiate big banks from the small fry and, then, disciplined analytics about whether, how and at what cost any such benefits constitute a subsidy. If the number derives from lapses in OLA – as I suspect it will – we need to look critically at OLA and repair it, not just consign ourselves to continued TBTF. 

Even if a big price tag is slapped on TBTF, the prospect of taxpayer bailout will distort financial markets and disadvantage competitors unless or until a mechanism to shut the biggest and baddest is well in place.

What's the OLA repair agenda? One of the biggest flaws in OLA is the lack of a cross-border way to handle systemically important financial institutions. U.S. regulators are talking on and on with their counterparts, but a lot of this won't come to much because most banks outside the U.S. are supposed to be national champions, not private entities slapped down by the market. Even worse, nonbank SIFIs have yet even to be addressed, meaning not only that there's no cross-border regime for them, but also still no way to plan for another AIG, Lehman or Bear Stearns. We've learned the hard way that systemic risk doesn't solely reside in depositories, but still all the talk – subsidy and resolution – is unduly focused solely on big banks.

Another unresolved problem in OLA is the uncertain resilience of the single-point-of-entry framework being constructed by the FDIC for big-bank SIFIs. In this strategy, a holding company is allowed to fail, its shareholders are wiped out and creditors' claims are converted into equity to recapitalize a bridge firm that inherits operating subsidiaries. To make SPOE work, SIFIs need a whole lot of "bail-in" debt at the parent level. But, if this debt is held by other SIFIs – which is likely – then would the bail-in structure accelerate contagion risk? Or, would the FDIC need to make these creditors whole – using its OLA discretion – and thus create yet another type of bail-out by way of the "bail-in"?

An array of OLA protections for derivatives and other "qualified financial contracts" further complicate the OLA question, although a lot of work on a new "chapter 14" bankruptcy framework for them may soon clear a lot of this up.

How to solve this conundrum? It takes not just urgent work on the subsidy question, but also rapid deployment of cures to OLA's remaining weaknesses. When the FDIC announced SPOE in December, it promised to turn to this as soon as possible. Six months later, we're still waiting. Without ready action, OLA will cease to be credible and, then, Congress won't stop with a big-bank subsidy. If regulators don't beat it to the punch, Congress will also stipulate a series of artificial size and activity limits that break up big banks, freeing nonbanks to start up the next systemic crisis.  

Karen Shaw Petrou is a managing partner at Federal Financial Analytics in Washington.