What Happens When the Next Too-Big-to-Fail Bank Goes Under?

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Martin J. Gruenberg, acting chairman of the FDIC

One of the great thorns in the side of the American public is that the too-big-to-fail banks that were the cause of the financial crisis are still around today. They are employing many of the same people and paying dividends to many of the same shareholders. And there has been no retribution for the havoc they’ve wrought upon the world economy.

This is surely frustrating, but perhaps a bigger concern is that these institutions are larger and more interconnected than they were before the crisis. If one of them were to fail — and these institutions are still weak by many standards — what would prevent it from dragging the global economy down into another colossal recession? Martin J. Gruenberg, the acting chairman of the FDIC sought to answer that question in a speech yesterday in Chicago.

Gruenberg laid out the FDIC’s new plan to take over the nation’s largest financial institutions if one were to fail, using powers granted to it and the Treasury Department by the 2010 Dodd-Frank financial reform bill.

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The plan centers on three main goals. Said Gruenberg:

 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.

So how would the FDIC go about nursing one of the U.S.’s mammoth financial institutions through a crisis? First, the FDIC would put the firm’s “holding company” into receivership. The holding company is the part of the firm that owns all  the subsidiaries. Some of the nation’s largest financial institutions own hundreds of subsidiaries, which are joined together by the holding company. Prior to Dodd-Frank, the FDIC  had the power  to resolve only federally insured banks and thrifts, and this was a crucial limitation when an investment bank like Lehman Brothers collapsed in 2008. With the new authority provided by Dodd-Frank, the FDIC will now be able to put any failed financial institution into receivership.

According to Gruenberg, the strength of taking just the holding company into receivership is that the subsidiaries can function on their own, upholding financial contracts and providing services for their clients. This strategy will help avoid the falling domino effect of the 2008 financial crisis, where one large bank failure caused many other institutions to go down as well.

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After the holding company is taken into receivership, the FDIC will transfer its assets into a new company, keeping those subsidiaries open that are solvent. Debt holders of the old company will become the owners of the new company, and shareholders will be wiped out. So all the stakeholders in the company can expect to suffer losses — just like in any normal bankruptcy proceeding.

To provide financing to keep this new bank going during the transition, the Dodd-Frank law set up an “Orderly Liquidation Fund” at the Treasury Department. Any losses to this fund must be “repaid from recoveries on the assets of the failed firm or from assessments against the largest, most complex financial institutions,” said Gruenberg, adding that taxpayers will not be allowed to bear any loss from such a resolution. He continued,

The OLF does address a critical issue to prevent a system-wide collapse, as we saw with the Lehman bankruptcy, because it provides an emergency source of liquidity to allow the bridge financial company to complete transactions that provide real value and prevent contagion effects.

Another big hurdle the FDIC faces in protecting subsidiaries of failed firms is that many of those subsidiaries are located abroad. This requires American regulators to work closely with foreign governments and align their policies to prevent regulatory incompatibilities from exacerbating a crisis, as was the case in 2008. According to Gruenberg, this means working most closely with authorities in the United Kingdom, where many subsidiaries of U.S. financial institutions are located. “Working with the authorities in the U.K. … we have examined potential impediments to efficient resolutions in depth, and are, on a cooperative basis, in the process of exploring methods of resolving them.”

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Given the alternatives, the FDIC’s plan sounds like the best of all worlds. It allows for the government to resolve failed institutions in an orderly way, without bailing out those firms. Shareholders and executives would be given the boot, and the firm would be turned over to a new set of owners while still being kept in private hands. Indeed, the whole purpose of this speech was to give a warning to big banks and those who lend to them that in the future, failing will come with consequences.

However, not everybody is convinced. Most Republican lawmakers remain opposed to Dodd-Frank and seek to repeal it. According to a report issued last year from Republican members of the House Financial Services Committee, these critics aren’t confident that taxpayers won’t be on the hook for bank losses while failed institutions are in receivership. They argue that in an extreme circumstance, the FDIC and Treasury will not stick to the law’s mandate that taxpayers’ funds not be used to pay back creditors and will instead force the public to make failed banks’ creditors whole.

But if we can’t trust government officials to follow the law, debating the law at all seems like a waste of time. In the heat of the moment, this plan to wind down giant institutions is the best we have. Of course, finding a way to break up the banks may be the best path to making sure 2008 never happens again. But it’s hard to see how to do that without aggressive government intervention — something I doubt House Republicans are ready to endorse any time soon.

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