A vast literature has arisen discussing the tortured issue of taxpayer-funded bail-outs and the intimately related concept of ‘Too Big to Fail’ (TBTF). The idea behind it is relatively simple. TBTF describes a financial institution whose failure would cause such a tremendous level of harm to the economy that the responsible government will attempt to rescue it at almost any cost. The Dodd-Frank Act (DFA) represents the primary US response to this issue. Title II of the Act is one of the key additions to the systemic risk management infrastructure. It can be summarised as a tool to prevent bail-outs (ie the use of taxpayer funds to prevent the failure of an institution). Title II contains the Orderly Liquidation Authority (OLA), a brand-new regulatory armoury granting the Federal Deposit Insurance Corporation (FDIC) wide powers for resolving Systemically Important Financial Institutions (SIFIs). There was undeniably a perception during the Crisis that the Bankruptcy Code was not equipped to deal with the failure of certain institutions. This essentially left regulators with the sole option of a taxpayer-funded bailout.[1] The OLA hopes to break this deadlock by attempting to offer a credible means to allow a SIFI to fail in future (“making failure feasible”).[2] A short but ostensibly crucial provision, § 214, appears to robustly shore up the anti-bail-out mandate:
All financial companies put into receivership under this title shall be liquidated. No taxpayer funds shall be used to prevent the liquidation of any financial company under this title.[3]
Congress made clear that failed SIFIs are not to be rehabilitated in the future—apparently a clear policy decision that Wall Street would have no second bite of the cherry, and that the rosy implied government guarantee days are over.[4] This stunted section sits awkwardly beside the sprawling § 210, which establishes (inter alia) the FDIC’s power to create and operate a bridge financial company (BFC) and transfer assets and liabilities to it, as well as the Orderly Liquidation Fund (OLF), which makes 100% of the value of the failed institution’s assets available to the FDIC as a Treasury loan.[5] The section is even more confusing in light of the apparent favorite strategy proposition: Single Point of Entry (SPOE). SPOE involves placing the ultimate holding company of the failed institution into a Title II proceeding, and transferring all of the operating subsidiaries to a newly created BHC. The question of what, if anything, § 214 is likely to achieve becomes most acute when considered as applied to Global Systemically Important Banks (G-SIBs), which represent the very largest SIFIs. The proposed Total Loss Absorbency Capacity (TLAC) regime that would apply to G-SIBs seems to complicate the picture even further.
This essay considers whether the OLA as conceived in light of the SPOE and TLAC regimes can seriously be expected to give real meaning to the liquidation prescription. It begins by briefly outlining the OLA regime. The SPOE strategy is then considered in more detail before the TLAC regime and its complications are added to the picture. The essay aims to show that § 214 will not end bail-out under the current proposals, and should not be construed as such. It is argued instead that it is merely a part of Title II, which does go some way to tackling TBTF by placing any bail-out type activity in a secure framework. The policy implications of this are also discussed.
THE OLA FRAMEWORK
The FDIC has traditionally been responsible for the resolution of insured depository institutions, and remains so under the existing regime.[6] The OLA represents an expansion of the FDIC’s powers to permit its resolution of any “financial company” whose administration under a Code proceeding “would have serious adverse effects on the financial stability of the United States”.[7] The bar for initiating a proceeding is designed to admit only genuine SIFIs, and involves multiple regulators and government offices, but is otherwise not excessively stringent. In addition to the systemic stability requirement, the institution must be “in default or in danger of default”,[8] and there cannot be a “viable private sector alternative.”[9] “Financial company” includes bank holding companies, designated SIFIs, and any other company predominantly engaged in financial services.[10] The process is designed to move quickly (especially compared with a Bankruptcy Code procedure). The Federal Reserve Board, acting in concert with the FDIC, SEC, or Federal Insurance Office, must recommend the use of Title II to the Secretary of the Treasury.[11] The Secretary then, in consultation with the President, will obtain the consent of the institution’s board of directors in order to proceed with the OLA resolution.[12] If the board refuses, the Secretary files a petition in the federal district court in Washington, DC.[13] The court has twenty-four hours to decide whether the Secretary’s determination that the institution satisfies the § 203 requirements[14] is “arbitrary and capricious”.[15] A firm entering OLA resolution is termed a “covered financial company”.[16]
The powers of the FDIC (contained in § 210)[17] are extremely broad once resolution proceeds. The FDIC assumes “all rights, titles, powers, and privileges of the covered financial company and its assets, and of any stockholder, member, officer, or director” of the covered firm.[18] It has nearly unfettered discretion to dispose of the company or any of its assets either directly into the market or by transfer to a newly created BFC.[19] Critically, the FDIC has access to the OLF, a fund established at the Treasury, “which shall be available to … carry out the authorities contained in this title”.[20] Funds will be available immediately in the amount of 10% of the covered institution’s total consolidated assets.[21] Once a determination has been made about the value of the total consolidated assets available for repayment funds will be available up to 90% of the calculated amount.[22] This means that the FDIC is authorised to take control of the covered institution, transfer all of its operating subsidiaries to a new holding company (created as a BFC), and (if necessary) guarantee all of its liabilities (no matter how large the balance sheet). As discussed in the next section, this is precisely what the FDIC has indicated it will do.
THE SPOE STRATEGY
The FDIC has indicated that it will employ a single point of entry (‘SPOE’) strategy.[23] This involves placing only the ultimate holding company of the distressed firm into resolution and thereby assuming the entire structure at once.[24] A bridge financial company will be created and the covered subsidiaries transferred to a BFC.[25] Liabilities and toxic assets are left behind in the covered firm.[26] The equity interests in the covered firm are then wiped out and long term creditors will have their claims converted into equity in the BFC.[27] The claimed benefits of this strategy are twofold, stemming from the fact that operating subsidiaries are not placed into insolvency or resolution proceedings (as would be the case under a Multiple POE approach). First, the operating subsidiaries of the covered firm continue without interruption.[28] Second, cross border complications are minimised because foreign insolvency proceedings are avoided.[29]
What happens next is not certain. The FDIC stated that the plan “might result in the [BFC] being divided into several companies or parts of entities being sold to third parties”, and that “the [BFC] might become smaller and less complex”.[30] Chairman Gruenberg has stated more recently that “an explicit objective is to ensure that no systemically significant entity emerges from this process”.[31] The first quotations come from a request for notice and comment, which might be expected to be phrased more tentatively. Chairman Gruenberg’s comment seems more committed. Nevertheless, “might” is hardly firm at all and an “objective”, even if “explicit”, is still not a firm statement that a break-up would take place. The FDIC does not seem at all certain that the OLA procedure would not simply replace the ultimate holding company of a failed SIFI with a new holding company. Their tone suggests that the OLA could well be used to simply recapitalise the failed SIFI by wiping out the covered firm’s shareholders, bailing in its long term shareholders, and selling equity in the new firm. All the while the OLF supports the BHC’s assets and provides working capital to ensure liquidity. So far it does not seem that the § 214 command is being taken very seriously. A brief detour into the TLAC proposal will help to add colour to this analysis.
G-SIBS AND TLAC PROPOSAL
The FDIC has not yet explicitly endorsed the SPOE approach as its primary resolution strategy. The door to a MPOE approach has been left ajar. The Federal Reserve has been less tentative: the TLAC proposal “is primarily focused on implementing the SPOE resolution strategy” for G-SIBs.[32] G-SIBs are the largest banking organisations designated as globally systemically important by the Financial Stability Board (FSB).[33] The proposal requires US G-SIBs to hold more capital and TLAC eligible debt to increase their ability to sustain losses without threat to their solvency.[34] The capital component must be satisfied by Tier 1 capital (ie common stock and non-cumulative perpetual preferred stock). TLAC eligible debt must be issued directly by the G-SIB ultimate parent company; must be unsecured and carry no credit enhancement from any of its subsidiaries; must be subordinated; may not be convertible into equity prior to the start date of an FDIC resolution; and must bear at least a one year maturity (a 50% penalty applies to debt with a maturity under two years).[35] Essentially this is plain vanilla junior debt with a maturity that ensures it is not runnable. Further, the clean holding company provisions seek to ensure the holding company does not issue other types of runnable short term debt that could create a liquidity shock.[36] Such funding activity must therefore occur at a subsidiary level.
§214—A LIE TO THE TAXPAYER?
The resulting proposed regime might be somewhat alarming to a person who was quoted the § 214 liquidation requirement for failed SIFIs, which would appear to ensure that the associated costs are borne by Wall Street investors and creditors. Take the example of a failed G-SIB (a calamitous, Lehman-esque event). The holding company would be seized by the FDIC as receiver. The operating subsidiaries would be transferred to a BHC, and the OLF would be used to shore up and stabilise its balance sheet. The creditors of the subsidiaries (many of them Wall Street creditors facing short term wholesale funding transactions of the runnable type not permitted for the covered firm—ie risky funding activity) would be fully protected. The equity and TLAC debt holders of the covered firm would be wiped out. The FDIC would appoint (extremely expensive) expertise to help run the BHC, at least for a time. Particularly in a crisis situation that would admit a G-SIB failure it is highly unlikely that a credible buyer could exist that would support the acquisition of such a vast balance sheet, and especially not quickly. It is worth noting the credible argument that the purchasers of TLAC debt are likely to be pension and mutual funds.[37] This means that the people bearing the first losses of a G-SIB failure are not the Wall Street creditors, who are safely protected in the (as of yet unliquidated) BHC, but the retail investors funding their pensions and growing their savings.
This picture does not seem to match the apparently clear wording of the § 214 bail-out proscription. A cynic might say this is not surprising when it is considered that the SPOE strategy is based on Wall Street’s response to Title II. § 214 obviously threatened the discount enjoyed by SIFIs on their debt, which derives from the pre-crisis implied government guarantee of their balance sheets (the TBTF issue). Their answer was to develop the “recapitalisation-within-resolution” strategy,[38] which came to form the “conceptual foundation” for the SPOE strategy.[39] A realist might equally say that this is not surprising given that § 214 was never a core part of Title II, only being proposed by Senator Barbara Boxer late in the game and always considered in light of the OLA and OLF powers.[40]
What to make of this situation? The cynic might be told that a proposal from Wall Street has a rightful place in the regulator’s strategy research. These firms might have their clear incentives, but they also undeniably have some of the most valuable expertise. Further, the Crisis precipitated significant management turnover, and the SPOE proposal must be read in conjunction with the various and extensive other reforms in the DFA and elsewhere that target the type of behaviour that led to the crisis. The realist might also be told that a late addition does not mean it should be devoid of meaning—but it is worth considering whether the spirit of the provision really does envisage an entire liquidation of a SIFI the size of, eg JPMC. Such an event would be a tremendous exercise in value destruction, since it is a basic economic principle that the value of a financial institution’s balance sheet is far greater as a going concern. As has been colourfully observed, bail-outs are “beyond annoying”.[41] That does not mean that some kind of magic wand can be waved to stop them from happening. This is perhaps an unfair characterisation of § 214. It does, however, suggest that a world in which SIFIs are tolerated is a world in which some from of bail-out system, eg through an SPOE strategy that uses TLAC to shift losses to those that can bear them without systemic collapse, is also tolerated. This is the irreducible core of the TBTF problem. Although this paper is not advocating bail-outs, it is worth noting that a consolidated financial system does have benefits. SIFIs enjoy cheaper funding (which allows them to lend more, which stimulates economic growth). They consolidate expertise (how many Jamie Dimons are there out there—to use a trite example). They provide regulators with a complex but centralised picture. They employ economies of scale and of scope. At the very least it seems far too simplistic to assert that no-one benefits from a SIFI economy and everyone loses from a bail-out regime.
CONCLUSION
The exact intentions behind § 214 must remain a mystery. This paper has sought to show that the Title II system, as conceived in light of the SPOE and TLAC proposals, most likely would not result in the entire liquidation of a SIFI (or more specifically a G-SIB if TLAC is in play) without any taxpayer funding involvement. It has also considered, however, that this is unlikely to be a desirable event in any case. That the course has tended away from an aggressive liquidation strategy and towards a controlled bail-out type regime, even with the memory of the Financial Crisis still fresh in the minds of those involved, suggests that it would not be realistic to consider § 214 a genuine attempt to end any form of bail-out. Title II at least creates a workable structure for the use of taxpayer funds to prevent value destruction in an undercapitalised SIFI, which will in any case not go to the covered financial company (and therefore satisfies the wording strictly construed). It seems that Title II does therefore tackle the TBTF problem, even if it does not eradicate it. While beyond the scope of this paper, more aggressive proposals have been made that involve the forced break up of existing SIFIs, or reform of the Bankruptcy Code to accommodate financial institutions. The unavoidable truth is that it is impossible to be certain whether these will work. The real question is whether we would rather live with the risk that taxpayer funds will be used to support SIFIs, or with the risk that our economy would not function as we desire without them.
[1] Coerced mergers, more colourfully known as ‘shotgun weddings’, were also used (notably with Bear Stearns and Wachovia: Zaring D, ‘The Post-Crisis and Its Critics’ [2010] 12 University of Pennsylvania Journal of Business Law 1169, 1180). They represent the same issues as bail-outs, however, in that they tend to require massive taxpayer-backed government guarantees (ibid).
[2] This characterisation is borrowed from an argument applied in support of bankruptcy reform and the creation of a new Chapter 14 for financial institutions: see generally The Hoover Institution, Making Failure Feasible: How Bankruptcy Reform Can End ‘Too Big to Fail’ (eds Scott KE, Jackson TH and Taylor JB, Hoover 2015). The Institute, of course, argues that the OLA falls short of the mark (ibid).
[3] 12 USC 5394(a).
[4] Senate Report No 111-176, 4 (2010): “Once a failing financial company is placed under [the OLA], liquidation is the only option; the failing financial company may not be kept open or rehabilitated”.
[5] 12 USC 5390 (BFC power at 5390(h); OLF power at 5390(n)).
[6] Intervention is determined under Federal Deposit Insurance Act § 1821. The FDIC is ultimately responsible for any shortfall in the repayment of the bank’s depositors. Deposits are the predominant funding technology for most IDIs, so it makes sense for the FDIC (as the bank’s largest contingent creditor) to administer their resolution. Whether the FDIC has the requisite expertise to resolve a SIFI is questionable, and is picked up later.
[7] 12 USC 5383(b)(2).
[8] 12 USC 5383(b)(1). The definition is broader than an ordinary definition of insolvency. Balance sheet cash flow insolvency are caught, but so is the likelihood that capital will be irreplaceably substantially entirely depleted, as well as situations where a Chapter 11 filing has been made or is likely promptly to be made: 12 USC 5383(c)(4). At least one commentator has warned that this final possibility may place the OLA in a race with a Ch 11 filing, which could distort the quality of decision-making and create systemic costs: Adams SD, ‘Swap Safe Harbors in Bankruptcy and Dodd-Frank: A Structural Analysis’ [2014] 20 Stanford Journal of Law, Business, and Finance 91, 111–12.
[9] 12 USC 5383(b)(3). Presumably this envisions a regulator-broker private acquisition of a distressed SIFI (see n 2 above). These may be more difficult after the amendments made to § 13 of the Federal Reserve Act (12 USC 343) through Dodd Frank (§ 1101(a)) that prevent financial assistance from being offered to a particular institution unless it is as part of “any program or facility with broad-based eligibility”. Such transactions are not without risk—they further consolidate the financial sector, and can be seen as ‘kicking the can down the road’ rather than directly dealing with the issues that caused insolvency: Jackson and Skeel, “Dynamic Resolution of Large Financial Institutions” 456. It may be responded that the acquiring institution will work the acquisition pure, and that no inherent flaws may have existed if a liquidity shock caused the distress.
[10] 12 USC 5381(a)(11)(B)(i)-(iii).
[11] 12 USC 5383(a). The SEC and FIO act in the case of broker-dealers and insurance companies respectively. The FDIC is still consulted. A 2/3 majority of the Federal Reserve Board and the board of the relevant regulator must vote in favour of action.
[12] 12 USC 5382(a)(1)(A)(i).
[13] Ibid.
[14] 12 USC 5383.
[15] 12 USC 5382(a)(1)(A)(iii). The time limit is derived from 12 USC 5382(a)(1)(A)(v)(I), which grants the petition by operation of law if no court determination is made.
[16] 12 USC § 5381(a)(7). If the firm is a broker-dealer it is a “covered broker or dealer”: 12 USC § 5381(a)(8).
[17] 12 USC 5390.
[18] 12 USC 5390(a)(1)(A)(i).
[19] 12 USC 5390(a). BFC creation power at § 5390(a)(1)(F) and § 5390(h).
[20] 12 USC 5390(n)(1).
[21] 12 USC 5390(n)(6)(A).
[22] 12 USC 5390(n)(6)(B).
[23] FDIC Chairman Martin Gruenberg described it as “the most promising resolution strategy” in a 2012 speech: Remarks by FDIC Chairman Gruenberg MJ at the Federal Reserve Bank of Chicago Bank Structure Conference, May 10 2012, available at https://www.fdic.gov/news/news/speeches/archives/2012/spmay1012.html, last accessed March 29 2018. It later reiterated this in conjunction with the Bank of England: FDIC and Bank of England, ‘Resolving Globally Active, Systemically Important, Financial Institutions (December 10 2012) 6, available at https://www.fdic.gov/about/srac/2012/gsifi.pdf, last accessed March 29 2018.
[24] Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 FR 76,614 (Dec 18 2013).
[25] Remarks by FDIC Chairman Gruenberg MJ. See further Barr MS, Jackson HE and Tahyar ME, Financial Regulation: Law and Policy (Foundation Press 2016) 931.
[26] Ibid.
[27] FDIC, ‘Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy’ 78 FR 76614 (December 18 2013), available at https://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-b_fr.pdf, last accessed March 29 2018.
[28] FDIC and Bank of England, ‘Resolution of Systemically Important Financial Institutions’.
[29] Ibid. Doubt has been expressed whether this benefit would materialise: Wilmarth AE (Jr), ‘SPOE + TLAC = More Bailouts for Wall Street’ [2016] 35 Banking & Financial Services Policy Report 1, 7 (pointing out that “despite extensive efforts by the G20 and FSB, developed countries have not yet agreed on a comprehensive international framework for resolving G-SIBs” (ibid)).
[30] FDIC, ‘Resolution of Systemically Important Financial Institutions’ 76620.
[31] Remarks by FDIC Chairman Gruenberg MJ at the FDIC Banking Research Conference, September 17 2015, available at https://www.fdic.gov/news/news/speeches/spsep1715.html, last accessed March 29 2018.
[32] Board of Governors of the Federal Reserve, Notice of Proposed Rulemaking: “Total Loss-Absorbing Capacity, Long-Term Debt, and Clean Holding Company Requirements for US Bank Holding Companies and Intermediate Holding Companies of Systemically Important Foreign Banking Organizations”, 80 Federal Register 74926 (November 30 2015) (“TLAC Proposal”).
[33] The usual suspects are on the US list: JPMC, BoA, WF, Citi, GS, MS, BNYM, and State Street.
[34] Federal Reserve, “TLAC Proposal” 74934.
[35] See generally: ibid.
[36] Ibid.
[37] Wilmarth, “SPOE + TLAC” 5. The argument (ibid 5-6) is based on the requirement in the proposal that holding company creditors be those who could experience loss without threatening systemic stability. This rules out depository institutions (which would be required to deduct TLAC debt from their regulatory capital). It seems likely that insurance companies would be similarly restricted. Further, hedge funds are major G-SIB creditors due to their prime brokerage relationships, also suggesting they would be excluded from the TLAC market.
[38] Wilmarth AE (Jr), “The Financial Industry’s Plan for Resolving Failed Megabanks Will Ensure Future Bailouts for Wall Street” [2015] 50 Georgia Law Review 43, 53-54 (describing development of this plan).
[39] Wilmarth, “SPOE + TLAC” 1.
[40] Jackson and Skeel, “Dynamic Resolution of Large Financial Institutions” 441.
[41] Lubben SJ, “A Functional Analysis of SIFI Insolvency” [2018] Texas Law Review (forthcoming), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3123135, last accessed March 29 2018.
