The FDIC Continues to Promote the Fantasy That It Can Resolve Megabanks

Due to being a bit under the gun before taking off on holiday (I hope you all enjoyed the posts from Matt Stoller, Lambert, and the other guest writers), we didn’t address a May 10 speech by the acting FDIC chairman, Martin Gruenberg, on the FDIC’s current thinking on how to resolve so called systemically important financial institutions, or SIFIs. I’m turning to this now because I see some people who ought to know better, such as the normally solid John Hussmann, taking the FDIC”s claims at face value.

As an overview, Dodd Frank gave the FDIC new powers for resolving large, complex financial institutions, which are often referred to as “orderly liquidiation authority” or “Title II resolutions”. Nowhere does the Gruenberg speech mention that the FDIC does not have the authority to put a megabank down; it requires Fed and Treasury approval as well. So it seems unlikely, in the wake of Lehman, that any Administration is going to hazard euthanizing a foundering financial institution using an untested processes.

It’s worth noting that the FDIC has retreated from its position in a paper it published a bit more than a year ago, a description of how it would have used its expanded powers in the case of Lehman. Gruenber’s speech is de facto climbdown from that piece, which we shredded in a series of posts (here, here, here and here; it took that many rounds to beat back staunch administration defender Economics of Contempt.

The guts of the latest FDIC scheme is to resolve only the holding company and keep the healthy subsidiaries, including all foreign subsidiaries, going on a business-as-usual basis:

…the most promising resolution strategy from our point view will be to place the parent company into receivership and to pass its assets, principally investments in its subsidiaries, to a newly created bridge holding company. This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings. Because these subsidiaries will remain open and operating as going-concern counterparties, we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal.

The subsidiaries would be moved over to a new holding company; the equity in NewCo would become an asset of the holding company now in receivership. The old equityholders would likely be wiped out and the bondholders may wind up taking losses.

This all sounds wonderfully tidy and neat, right? Problem is it won’t work.

The rather large fly in the ointment is that counteryparties would be concerned that putting the holding company into what Satyajit Das calls “a strange hypnotized state” would trigger cross defaults across agreements, including derivative agreements, where the holding company had guaranteed a contract. Per Das:

This would mean all derivative contracts could be terminated and this may trigger large payments which the FDIC may need to fund (i.e. is the American taxpayer going to pay out counterparties claims?).

Remember that in the US, banks (ex Morgan Stanley) have their derivatives booked in the depositary, which means any losses to depositors as a result of derivatives positions gone bad would be borne by taxpayers. And as we’ve written at excruciating length with respect to the Lehman bankruptcy, the magnitude of the losses cannot be explained by overvalued assets plus the costs resulting from the disorderly collapse. Derivatives positions blowing out (as well as counterparties taking advantage of options in how contracts can be closed out and valued) were a major contributor to the size of the Lehman black hole.

Moreover, even if this novel procedure did not trigger cross defaults, counterparties to the subsidiaries would seek to terminate contracts. Unless the FDIC (or another government funding source) were to stand behind the subsidiaries, including foreign subs, this attempt at a holding company resolution would trigger the sort of subsidiary level distress that the FDIC intends to avoid. Many banks’ foreign operations have little or no capital in them, relying on a “home-host” arrangement in which the mother ship (the foreign parent) sends more funds and/or capital when local regulators or counterparties require it. Concerns about how badly this model worked in the Lehman failure, when the US parent raided the London broker-dealer in a last-ditch effort to save itself, have led to more regulators adopting a “ring fencing” posture, requiring local operations to be better able to stand on their own. This posture is becoming more widely accepted abroad, in part due to the view of leading international regulators and international bank lobbying groups that Dodd Frank resolutions won’t work, due to the failure of the US law to recognize that bankruptcy (and resolution) falls to nation-based courts. As we noted in an earlier post:

For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ [with the FDIC]. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it “recognizes the strong likelihood of ring fencing in a crisis” due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that “helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.” In other words, it accepts a national process as inevitable and recommends dealing with that reality.

And note also: FDIC asserts, in their Lehman counterfactual (and, they assume, in Title II resolutions generally), that the local regulator would have cooperated. Yet the FSA, in its Turner Review, has fallen in line with the BIS ring-fencing notion. The FSA is moving towards requiring local entities be better capitalized and is placing little faith in yet to be realized greater international coordination. Both documents pre-date the finalization of Dodd-Frank, which, in its obliviousness to the international dimension, simply confirms the prior BIS/FSA line.

Similarly, the Institute for International Finance, a blue chip group from the industry (meaning it has every reason to depict Article II as workable, since the alternative is structural remedies, aka breaking up banks, and/or much higher capital levels for national entities, would have a disruptive impact on their operations) has been on the same page as the BIS and has seen nothing in Dodd-Frank to change its mind: see pages 31-2 of their latest on this subject:

Title II remains problematic in the limited attention that it pays to cross-border issues…

…cooperation and coordination is, under Dodd-Frank, dependent upon the goodwill of the different parties and perceived common interest in the circumstances…

Much, accordingly, remains to be done to render the Dodd-Frank approach appropriate for application in the context of cross-border financial groups.

And the ring-fencing isn’t just a regulatory response to the heightened awareness of the difficulties of winding up failed banks; it’s also a defensive posture taken when financial players get nervous about counterparty risk. In an important article, Gillian Tett described how financial integration in the Eurozone has gone into reverse (aside: a reappearance of the Tett of 2005-2007 looks to be a crisis indicator):

….amid all the speculation about Grexit, they told me, banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

In the long run, a return to more autarkical finance may be inevitable. As Carmen Reinhart and Ken Rogoff found, high levels of international capital flows are associated with large and more frequent financial crises, so reducing the level of cross-border money movement may be necessary to increase financial stability. But having sudden eve-of-possible crisis changes in behavior can in and of itself trigger dislocations. As Richard Bookstaber pointed out in his book A Demon of Our Own Design, in tightly coupled systems, measures to reduce risk that focus on particularly institutions or issues typically make matters worse. And that may well happen here. For instance, if Mr. Market were to believe the Fed, senior bondholders should demand higher interest rates in return for the risk of being exposed to haircuts in the case of distress, which is something they had good reason to think they’d be spared, given that the Treasury Department has had a “bondholders must not take losses” policy. Note that this move comes when regulators are pressuring banks to reduce their dependence on repo financing and raise more term funding.

It would have been much better for the authorities to make a full bore effort to discourage the use of products that have limited social value and contribute to the excessive integration of firms and markets. Credit default swaps and complex over-the-counter derivatives top our list. But despite the severity of the crisis, regulators and politicians were unwilling to challenge the primacy of the bankers, with the result that the FDIC continues to pretend that an inadequate approach like Dodd Frank resolutions will work. With distress in Europe rising and Morgan Stanley looking wobbly, we are likely to see sooner rather than later how much the failure to implement real reforms will cost us all.

This post originally appeared at naked capitalism and is posted with permission.

2 Responses to "The FDIC Continues to Promote the Fantasy That It Can Resolve Megabanks"

  1. Jim Davey   June 4, 2012 at 10:49 pm

    Why not tell the TBTF banks to stop playing casino, get back to banking, or no more FDIC on the window see how fast Jaime learns he is not top dog. Just for fun do JP Morgan Chase first with zero warning. (Don't forget the banks did stop paying FDIC under a Republican House, Senate & President.)

  2. Jim Davey   June 4, 2012 at 11:02 pm

    Why not tell the TBTF banks to stop playing casino