WORD ON THE STREET: Before the Dodd-Frank Act, the government did not have the authority to unwind large, highly leveraged and substantially interconnected financial firms that failed – such as Bear Stearns, Lehman Brothers and AIG – without disrupting the broader financial system. Firms benefited from the perception that they were ‘too big to fail’ – a presumption that they would receive government assistance in the event of failure.
Such a presumption reduced market discipline and encouraged excessive risk-taking by firms. It provided an artificial incentive for large firms to grow even larger. It created an unlevel playing field with smaller firms. And when the financial crisis hit, it left the government with the untenable choice between taxpayer-funded bailouts and financial collapse.
Today, major financial firms will now be subject to heightened prudential standards, including higher capital and liquidity requirements, stress tests, and "living wills." Major financial firms will be required by these standards to internalize the costs that they impose on the system, which will give them incentives to shrink and reduce their complexity, leverage and interconnections. And should such a firm fail, there will be a bigger capital buffer to absorb losses.
These measures will help to reduce risks in and among the largest financial institutions. In the event that such an institution fails, these actions will minimize the risk that any individual firm's failure will pose a danger to the stability of the financial system. Thus, bankruptcy proceedings will remain the dominant option for handling the failure of a non-bank financial institution.
The crisis, however, showed that the U.S. government simply did not have the tools to respond effectively when the failure of one or more major financial institution threatened financial stability. As Lehman's collapse showed quite starkly, there are times when the existing options under the Bankruptcy Code are simply not adequate to deal with the insolvency of large, complex and interconnected financial institutions in times of severe crisis.
That is why the Dodd-Frank Act permits the government, in limited circumstances, to resolve the largest and most interconnected financial companies outside of the traditional bankruptcy regime and consistent with the approach long taken for bank failures. This is the final step in addressing the problem of moral hazard: to make sure that we have the capacity – as we do now for banks and thrifts – to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system.
Under the orderly liquidation authority, the Federal Deposit Insurance Corp. (FDIC) is provided with the tools to wind down a major financial firm on the brink of failure. Shareholders and other providers of regulatory capital to the firm will be forced to absorb any losses. Management of the firm culpable for its losses will be terminated. Critical assets and liabilities of the firm can be transferred to a bridge institution, while any remainder is left in the receivership estate. Any required funding for liquidity can be obtained through Treasury borrowing that is automatically repaid from the assets of the failed firm or, if necessary, from an ex post assessment on the largest financial firms. In that manner, the resolution authority allows the government to impose losses on shareholders and creditors without exposing the system to a sudden, disorderly failure that puts the financial sector as a whole at risk.
The objectives of the resolution regime differ from those of the Bankruptcy Code. The purpose of the Bankruptcy Code is to reorganize or liquidate a failing firm ‘for the benefit of its creditors.’ The resolution authority is structured to manage the failure of a financial firm in a manner that protects taxpayers and the broader economy and promotes stability in the financial system. This purpose is explicitly different than the purposes of the Bankruptcy Code, but that is why the act is narrowly tailored to situations in which there are exceptional threats to financial stability.
The Dodd-Frank approach is modeled on the long-standing regime for bank failure. There are significant and tested safeguards in the act modeled on the bank failure law to protect creditor rights. In addition, creditors in the resolution process are protected by the same system of judicial review that has existed for the FDIC (and its predecessors) for its receivership and conservatorship authorities for more than 75 years.
The act seeks to respect the Bankruptcy Code's fundamental principles of fairness and equity among similarly situated stakeholders. As is the case under the Bankruptcy Code's best-interests test and under the model in place for bank resolution, in the limited circumstances where the act permits deviation from those principles, the act expressly guarantees that stakeholders will be made no worse off by a regulator's use of resolution authority than would be the case in a liquidation under Chapter 7 of the Bankruptcy Code. The act also maintains the right of an affected company to seek judicial review following the appointment of a receiver or conservator and a claimant's right to challenge a regulator's disallowance of its claim.
As with any new authority, the first and most central questions are: How would this work? How would it be different than what is possible today? What would happen if the U.S. government were once again faced with situations like those of September 2008?
Major financial institutions would have prepared a ‘living will’ embodying a liquidation strategy and, in most cases, a supervisory recovery plan to map out contingencies for how the firm would respond to avoid failure during a period of severe financial distress or instability. Such firms would have larger capital buffers in the event of economic stress, as well as stringent conditions imposed on the use of ‘hot’ money funding, including liquidity requirements over one-month and one-year time frames.
Regulators would have the authority to supervise the firm for system-wide risks and to impose tough prudential measures. As a firm faced capital or liquidity problems, regulators would order early remediation. But we need to have some humility about the future and our ability to predict and prevent every systemic failure of a major financial firm.
In a severe crisis, if one or more major financial firms fail, and prudential measures, remedial action and capital buffers prove inadequate, special resolution should be available. The Dodd-Frank Act builds in important safeguards for the use of such authority, including by requiring concurrence of the Treasury secretary, two-thirds of the board of the Federal Reserve and two-thirds of the board of the FDIC (or the Securities and Exchange Commission, in the case of a broker-dealer). If the financial firm's board does not consent, prompt judicial review is required.
A receivership under this authority would have three essential elements that would improve execution and outcomes relative to the tools that were available in fall 2008: First, the FDIC could swiftly replace the board and senior management with new managers. Second, a temporary stay of counterparty termination and netting rights, during which the FDIC could transfer qualified financial contracts to a third party or bridge institution without counterparty consent or court approval. Third, the ability to set up a bridge bank with secured financing from the FDIC to fund liquidity and capital needs, in order to mitigate the ‘knock on’ effects of any firm's failure; to fund its operations, pending its sale or winding down; and to preserve the business franchise, and protect viable assets of stronger subsidiaries pending their sale. This would have the potential to end the firm – wind it down – without contributing to system-wide failure.
In sum, the nation would no longer have to make the untenable choice between taxpayer bailouts and market chaos. Instead, the Dodd-Frank reforms provide the FDIC with the authority to wind down any firm whose failure would pose substantial risks to our financial system, in a way that will protect the economy while ensuring that the failed firm, and if necessary other large financial firms – not taxpayers – bear any costs.
To be sure, the creation of a domestic resolution authority is not enough. Large financial institutions operate globally. Resolution of a major firm will require international cooperation among regulators participating in existing supervisory colleges that monitor the largest financial firms. That is why it is so critical that other nations develop and implement special resolution regimes with similar tools and authorities, which is the essential first step to being able to resolve such global firms.
Michael S. Barr is a professor of law at the University of Michigan Law School. He also served as the U.S. Treasury Department's assistant secretary for financial institutions in 2009 and 2010. This article was adapted from June 14 testimony Barr delivered before the House Financial Services Committee's Subcommittee on Financial Institutions and Consumer Credit. His complete testimony can be accessed here.
