WORD ON THE STREET: I would like to take the opportunity to discuss the orderly resolution of systemically important financial institutions (SIFIs). The Dodd-Frank Act provided important new authorities to the Federal Deposit Insurance Corp. (FDIC) to resolve SIFIs. The question is whether the FDIC can develop the operational capability to utilize this authority effectively and a credible strategy under which an orderly resolution of a SIFI can be carried out without putting the financial system itself at risk.
The FDIC has taken a number of steps over the past year and a half to carry out its new systemic resolution responsibilities. First, the FDIC established a new Office of Complex Financial Institutions to carry out three core functions:
- monitor risk within and across these large, complex financial firms from the standpoint of resolution;
- conduct resolution planning and the development of strategies to respond to potential crisis situations; and
- coordinate with regulators overseas regarding the significant challenges associated with cross-border resolution.
For the past year, this office has been developing its own resolution plans in order to be ready to resolve a failing systemic financial company. These internal FDIC resolution plans, developed pursuant to the Orderly Liquidation Authority provided under Title II of Dodd-Frank, apply many of the same powers that the FDIC has long used to manage failed-bank receiverships to a failing SIFI. This internal resolution planning work is the foundation of the FDIC's implementation of its new responsibilities under Dodd-Frank.
Second, the FDIC has largely completed the basic rulemaking necessary to carry out its responsibilities under Dodd-Frank. Last July, the FDIC board approved a final rule implementing the Title II Orderly Liquidation Authority. This rulemaking addressed, among other things, the priority of claims and the treatment of similarly situated creditors.
Last September, the FDIC board adopted two rules regarding resolution plans that systemically important financial institutions will be required to prepare – the so-called ‘living wills.’ The first resolution plan rule, jointly issued with the Federal Reserve, requires bank holding companies with total consolidated assets of $50 billion or more, and certain nonbank financial companies that the Financial Stability Oversight Council designates as systemic, to develop, maintain and periodically submit resolution plans to regulators.
Complementing this joint rulemaking, the FDIC also issued another rule requiring any FDIC-insured depository institution with assets over $50 billion to develop, maintain and periodically submit plans outlining how the FDIC would resolve [its closing] through the FDIC's traditional resolution powers under the Federal Deposit Insurance Act.
These two resolution plan rulemakings are designed to work in tandem and complement each other by covering the full range of business lines, legal entities and capital-structure combinations within a large financial firm. Both of these resolution plan requirements will improve efficiencies, risk management and contingency planning at the institutions themselves. Importantly, they will supplement the FDIC's own resolution planning work with information that would help facilitate an orderly resolution in the event of failure.
With the joint rule final, the FDIC and the Federal Reserve have started the process of engaging with individual companies on the preparation of their resolution plans. The first plans, for companies with assets over $250 billion, are due in July.
The FDIC's resolution strategy has three key goals. The first is financial stability – ensuring that the failure of the firm does not place the financial system itself at risk. The second is accountability – ensuring that the investors in the failed firm bear the firm's losses. The third is viability – converting the failed firm through the public receivership process into a new, well capitalized and viable private-sector entity.
We can start by considering the type of firm that we may be presented with. It is likely to be a firm with several business lines – perhaps commercial banking, capital markets, global asset management, and transaction services – and which operates across national borders.
The corporate structure is likely to be a holding company with a parent at the top and multiple layers of subsidiaries. The number of subsidiaries will be in the hundreds, if not thousands. It is also likely that the structure of the legal entities within the company will not be aligned with the business lines. Additionally, intra-company risk transfers and financial relationships will not be transparent.
While there are numerous differences between a typical bank resolution and what the FDIC would face in resolving a SIFI, I want to focus on a few key differences.
The first is whether the proximate cause of failure is capital depletion or liquidity pressures. The typical path toward failure for an insured bank starts with bad loans. As the bank sets aside reserves for and charges off credit losses, capital ratios fall, triggering the requirements of prompt corrective action.
The bank is required to either raise capital or find a buyer. In the meantime, the bank normally continues to operate, in large measure because its major source of liquidity is insured deposits, which are not likely to run. Eventually, if it is unable to raise capital or find a buyer, the chartering agency closes the bank. Essentially, the bank has failed a market test of viability.
In the case of a large financial firm, it is likely that its problems also arise from the losses it has suffered in one or more of its business lines. However, it is also likely that this firm relies to a greater extent on market sources of funding and thus would face liquidity pressures not typically present in the case of an insured bank.
There are several implications to this. The FDIC and other regulators will have less time to craft a resolution. There may not be time for the firm to undergo a market test of viability. Finally, there may be a significant need to shore up liquidity in the course of the resolution.
In addition, the resolution of a large U.S. financial firm involves a more complex corporate structure than the resolution of a single insured bank. Large financial companies conduct business through multiple subsidiary legal entities with many interconnections owned by a parent holding company.
A resolution of the individual subsidiaries of the financial company would increase the likelihood of disruption and loss of franchise value by disrupting the interrelationships among the subsidiary companies. A much more promising approach, from the FDIC's point of view, is to place into receivership only the parent holding company while maintaining the subsidiary interconnections.
Another difference arises from sheer size alone. In the typical bank failure, there are a number of banks capable of quickly handling the financial, managerial and operational requirements of an acquisition. This is unlikely to be the case when a large financial firm fails. Even if it were the case, it may not be desirable to pursue a resolution that would result in an even larger, more complex institution. This suggests both the need to create a bridge financial institution and the means of returning control and ownership to private hands.
Finally, in the case of a failure of an insured bank, the FDIC acts both as a resolution authority and as a deposit insurer. In resolving a firm that is not an insured bank, the FDIC will be acting only as a resolution authority and not in any capacity that is analogous to deposit insurer.
The new resolution authority does not provide insurance or credit protection for creditors and counterparties, and creditors will always be subject to potential losses. This is a central feature of the new resolution authority and is designed to ensure that there is market accountability.
Martin J. Gruenberg is acting chairman of the Federal Deposit Insurance Corp. This article was adapted and edited from a presentation delivered May 10 before the Federal Reserve Bank of Chicago Bank Structure Conference. The full text is available online.