REQUIRED READING: I would like to discuss ‘too big to fail’ and the ongoing work since the financial crisis to end it. More than three years into this effort, there have been sweeping reforms to the regulation of large financial organizations in the U.S. and around the world. Substantial proportions of the new rules are designed to end the practice of bailing out such firms with taxpayer money.
The too-big-to-fail reform project is massive in scope. In my view, it holds real promise. But the project will take years to complete. Success is not assured.
In the meantime, some urge the adoption of more intrusive reforms, such as a return to Glass-Steagall-style activity limits, more stringent limits on size or systemic footprint, or a requirement that the largest institutions break up into much smaller pieces. I believe that public discussion and evaluation of these ideas is important. At a minimum, we need to thoroughly understand these alternatives in case the existing reform project falters.
It is worth noting that too-big-to-fail is not simply about size. A big institution is ‘too big’ when there is an expectation that government will do whatever it takes to rescue that institution from failure, thus bestowing an effective risk premium subsidy. Reforms to end too-big-to-fail must address the causes of this expectation.Â
In broad terms, these reforms seek to eliminate the expectation of bailouts in two ways: by significantly reducing the likelihood of systemic firm failures, and by greatly limiting the costs to society of such failures. When failures are unusual and the costs of such a failure are modest, the expectation at the heart of too-big-to-fail will be substantially eliminated.
My focus is principally on the second of these two aspects of reform: containing the costs and systemic risks from failures, a goal being advanced by work to create a credible resolution authority. I hope you won't mind if I draw on some of my own experiences over the years with too big to fail, beginning with my service at the Treasury Department during the administration of President George H.W. Bush. I joined the administration only a few years after the rescue of Continental Illinois, which is sometimes said to have codified the practice of too-big-to-fail.Â
In my years at Treasury, we faced a wave of well over 1,000 savings and loan and bank failures. That included the failure of the Bank of New England Corp., then the third-largest bank failure in U.S. history. It happened in January 1991, at a time of great stress in the financial system and the broader economy, and only days after 45 depository institutions in the region had been closed and 300,000 deposit accounts frozen.
My Treasury colleagues and I joined representatives of the Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve Board in a conference room on a Sunday morning. We came to understand that either the FDIC would protect all of the bank's depositors, without regard to deposit insurance limits, or there would likely be a run on all the money center banks the next morning – the first such run since 1933. We chose the first option, without dissent.
In the summer of 1991, we faced the Salomon Brothers crisis. Salomon, a global investment bank, was one of the largest financial institutions in the U.S., and the largest dealer in U.S. government securities. The firm came under severe market pressure after some of its traders were caught submitting phony bids in Treasury bond auctions.
As recounted in harrowing detail in the book ‘The Snowball,’ Salomon came within hours of failure over a weekend in late August 1991. Salomon was clearly understood to be outside the safety net, and I recall no discussion of a government rescue. But the firm's failure would almost certainly have caused massive disruption in the markets. To this day, I am grateful that we resolved that crisis with neither a bailout nor a failure.Â
Over 20 years later, both of these events still frame the too-big-to-fail reform agenda. Faced with the failure of a large commercial bank, we chose to extend the safety net rather than run the very real risk of a systemic depositor run. Our ‘near miss’ with Salomon in 1991 presaged the enormous damage that would result from the failure of Lehman Brothers, another investment bank, in 2008.
In fact, the dimension of the problem grew substantially over the years. Since 1991, the ratio of U.S. banking assets to annual gross domestic product in the U.S. has more than doubled, from 55% to 126%. Meanwhile, the percentage of those assets held by the largest three institutions has increased from 14% to 32%.Â
Bailouts may have been more tolerable in the early 1990s when they were rare and their use for a failing bank was uncertain. That is no longer the case. Recent years have seen large and numerous bailouts as a result of the financial crisis. The public, the regulatory community, and large financial institutions themselves all agree now that too-big-to-fail must end.Â
As I said earlier, reforms to end too-big-to-fail must wage the fight on two fronts. First, we need enhanced regulation to make large financial institution failures much less likely. Second, we need a credible mechanism to manage the failure of even the largest firms, without causing or amplifying a systemic crisis.Â Â
Let's survey what has been proposed and implemented thus far in that two-front war on too-big-to-fail.Â
Efforts to address the problem
Much has been done since the crisis to strengthen the regulation of large banking organizations. The highlights would begin with the Basel III capital and liquidity reforms, including the graduated risk-based capital surcharges for globally systemic financial firms. These reforms are in the process of implementation in the U.S. and elsewhere.
In addition, the Dodd-Frank Act imposes on the largest financial institutions enhanced prudential standards and also requires central clearing of derivatives. And banking regulators have implemented enhanced supervisory measures such as stress testing and recovery planning. I believe that these efforts collectively constitute a broad and well-structured agenda to strengthen the resilience of the financial system. The Federal Reserve and the rest of the regulatory community are working diligently to implement that agenda.Â
Today, risk-based capital and leverage ratios for banks of all sizes have improved materially since 2009 and are significantly above their levels in the years preceding the crisis. The banking sector overall also has substantially improved its liquidity position over the past few years. The system is undeniably stronger than before the crisis.
It is neither possible nor desirable to regulate large financial institutions so that they literally cannot fail. But regulation can limit the system-wide impact of such a failure. Let's review what has been done since the crisis to reduce the damage to the system from the failure of one of the very largest firms.
Under Dodd-Frank, nearly all financial institution failures, including those of large, complex institutions, will continue to be addressed as they were before passage of the new law. The holding company will be resolved in bankruptcy. Operating subsidiary failures will continue to be treated either under bankruptcy or, where applicable, under specialized resolution schemes, including the Federal Deposit Insurance Act for banks and the Securities Investor Protection Act for securities firms.Â
Dodd-Frank eliminated the authority used by the Federal Reserve and other regulators to bail out individual institutions during the crisis, including Bear Stearns, Citicorp, Bank of America and AIG. But Congress also recognized that there may be rare instances in which the failure of a large financial firm could threaten the financial stability of the U.S. To empower regulators to handle such a failure without destabilizing the financial system or exposing taxpayers to loss, Dodd-Frank created two important new regulatory tools.Â Â
First, the act requires large bank holding companies and nonbank financial firms designated by the Financial Stability Oversight Council to submit a resolution plan or ‘living will’ for their rapid and orderly resolution under the Bankruptcy Code. Second, the act created a new Orderly Liquidation Authority (OLA) as a backup to resolution in an ordinary bankruptcy.
The largest bank holding companies submitted their first annual ‘living wills’ to the Federal Reserve and the FDIC last summer. The initial round has yielded valuable information that is being used to identify and assess key challenges to resolvability under the Bankruptcy Code (Title I plans). The Title I plans will help to focus firm efforts to mitigate those challenges so that bankruptcy may be a viable resolution strategy for large institutions. These plans will also support development of the FDIC's backup resolution plans under OLA (Title II plans).Â
The resolution plan process is iterative by design. There is still much work to be done by firms, domestic and foreign regulators, and national governments. We remain committed to ensuring that this work is done quickly but responsibly in the coming years.
That brings us to the question of special resolution regimes. In October 2011, immediately before I was nominated to the Federal Reserve Board, I helped design a public simulation of the failure of a large financial institution under OLA. The cast included former senior government officials as well as leading experts from the private sector. The FDIC, the Federal Reserve and the industry offered their assistance as we developed the simulation.
From the outset, my earlier experience had led me to be skeptical about the possibility of resolving one of the largest financial companies without destabilizing the financial system. Today's global financial institutions are of staggering size and complexity. I believed that an attempt to resolve one of these firms – a firm with multiple business lines carried out through countless legal entities, across many jurisdictions and different legal systems – could easily spin out of control. The result could be greatly increased uncertainty for creditors and counterparties, which could trigger or accelerate a run on the failed institution that could quickly spread and destabilize the whole system.
As we developed the simulation, however, I came around to the view that it is possible to resolve a large, global financial institution. What changed my mind was the FDIC's innovative ‘single point of entry’ approach, which was just coming into focus in 2011. This approach is a classic simplifier, making theoretically possible something that seemed impossibly complex.Â
Under single-point-of-entry, the FDIC will be appointed receiver of only the top-tier parent holding company of the failed financial group. Promptly after the parent holding company is placed into receivership, the FDIC will transfer the assets of the parent company (primarily its investments in subsidiaries) to a bridge holding company. Equity claims of the failed parent company's shareholders will be wiped out, and claims of its unsecured debt holders will be written down as necessary to reflect any losses in the receivership that the shareholders cannot cover.
To capitalize the bridge holding company and the operating subsidiaries, and to permit transfer of ownership and control of the bridge company back to private hands, the FDIC will exchange the remaining claims of unsecured creditors of the parent for equity and/or debt claims of the bridge company. If necessary, the FDIC would provide temporary liquidity to the bridge company until the ‘bail-in’ of the failed parent company's creditors can be accomplished.
It is crucial to recognize how this approach addresses the problem of runs. Single-point-of-entry is designed to focus losses on the shareholders and long-term debt holders of the failed parent and to produce a well-capitalized bridge holding company in place of the failed parent. The critical operating subsidiaries would be well capitalized, and would remain open for business.
There would be much reduced incentives for creditors or customers of the operating subsidiaries to pull away, or for regulators to ring-fence or take other extraordinary measures. If the process can be fully worked out and understood by market participants, regulators, and the general public, it should work to resolve even the biggest institution without starting or accelerating a run, and without exposing taxpayers to loss.
Single-point-of-entry has important features in common with Chapter 11 bankruptcy reorganization. The principal differences in favor of OLA are the greater speed at which a firm can be placed into a resolution process and stabilized, the ability to avoid disruptive creditor actions, and the availability of temporary backup liquidity support to continue critical operations.
Some have proposed changes to adapt the Bankruptcy Code to the purpose of handling the failure of a large financial institution – for example, to allow the government to provide debtor in possession (DIP) financing, or to allow a firm's primary regulator to initiate a bankruptcy filing. At a minimum, these proposals would further limit the need for OLA to the rarest of cases.
As the development of the single-point-of-entry approach continues, it is important to continue to reduce the uncertainties that creditors and other market participants would face in connection with their potential treatment in OLA. Questions remain about how the FDIC will apply its broad statutory discretion.
For example: How will the FDIC exercise its discretion to dissimilarly treat creditors of the same class? How will a creditor's ‘minimum right of recovery’ be determined? And how will the FDIC value the failed firm?Â Stability demands that market participants have a reasonable degree of certainty about their treatment in OLA ex ante. This is an important concern.Â
To reduce uncertainty, the FDIC is working to provide market participants as much clarity as is feasible regarding its contemplated approach to the failure of a systemic U.S. firm. Regulators will always need to maintain some degree of flexibility to manage the evolving failure of a systemic financial firm. But greater clarity would increase the predictability of this new process and, thus, reduce the likelihood that creditors, counterparties, and customers would pull away from even a well-capitalized institution in OLA. I strongly support these efforts to provide more clarity to market participants.
Two remaining challenges loom large: ensuring that all systemic financial firms have sufficient unsecured long-term debt at the parent level to recapitalize a bridge holding company in OLA; and mitigating cross-border impediments to resolution of a multinational financial firm.
Jerome H. Powell is a governor of the Federal Reserve Board. This article is adapted and edited from a March 4 speech delivered at the Institute of International Bankers 2013 Washington Conference. The original text is online.