Resolution authority

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See also Break up banks, Narrow banks, National bank supervisor, Too big to fail.


Resolution authority in Dodd-Frank

The financial reform bill creates a new liquidation process that would allow the FDIC to seize control of large, interconnected financial companies, including broker-dealers, whose imminent failure threatens the stability of the U.S. financial system as a whole.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Wall Street Reform Act), was signed into law by President Obama on July 21. Among the Wall Street Reform Act's many sweeping changes, including provisions addressing consumer protection and executive compensation (both of which are the topics of prior LawFlash Alerts), Title II, titled Orderly Liquidation Authority, creates a new scheme, separate and apart from existing federal bankruptcy and state dissolution laws, through which a financial company can be liquidated.

The Basic Framework

The liquidation process begins when the Secretary of the US Treasury (the Secretary), upon the written recommendation of the Board of Governors of the Federal Reserve System (the Board) and the Federal Deposit Insurance Corporation (the FDIC) (in the case of a broker or dealer, the U.S. Securities and Exchange Commission (the SEC); in the case of an insurance company, the Director of the Federal Insurance Office) makes a systemic risk determination, with respect to any company, that, among other factors, fulfills the following criteria:

  • Such company is in default or at risk of default
  • The failure of such company and its resolution under otherwise applicable federal or state law would have a negative impact on the financial stability of the United States
  • Actions pursuant to an orderly liquidation (through the FDIC receivership process) would avoid or mitigate such adverse effects (taking into account, inter alia, the cost to the Treasury and the potential to increase excessive risk)
  • The company satisfies the definition of a Financial Company1 (a Covered Financial Company)

After making its determination, the Secretary, upon notice to the Covered Financial Company (and upon consent of such company's board of directors or applicable governing body), will appoint the FDIC as receiver for the Covered Financial Company. If the board of directors of the Covered Financial Company does not consent to the appointment of the FDIC as receiver, the Secretary can then petition the U.S. District Court for the District of Columbia (the D.C. Court) for an order authorizing the FDIC's appointment. Following a confidential hearing, any determination by the D.C. Court with respect to such petition is final and appealable, by either the Secretary or the board of directors, within 30 days, to the U.S. Court of Appeals for the Third Circuit,2 but is not subject to any stay or injunction pending an appeal.

If the Covered Financial Company is a broker or dealer, upon the appointment of the FDIC as receiver, the FDIC then appoints the Securities Investor Protection Corporation (SIPC) as trustee to the Covered Financial Company under the Securities Investor Protection Act of 1970 (SIPA). In such role, SIPC can exercise all of its powers and duties provided by SIPA, but cannot impede certain powers and actions of the FDIC. Likewise, the FDIC is subject to certain limitations in carrying out its receivership duties with respect to a covered broker-dealer—for example, the FDIC may not adversely affect or impair the rights of a customer with respect to payments on account of customer property or customer name securities.

Powers and Duties of the Receiver

Many of the powers and duties of the FDIC as receiver for a Covered Financial Company are similar to the powers and duties provided to a trustee or debtor-in-possession under the U.S. Bankruptcy Code or a receiver under state receivership laws. Basic powers include, without limitation:

The ability to succeed to all rights, titles, powers, and privileges of the Covered Financial Company, as well as the books, records, and assets with respect to such company The ability to operate the Covered Financial Company with all the powers of the members, shareholders, directors, and officers, including the right to collect and pay obligations, and perform all functions in the name of the company The ability to enter into contracts with third parties for assistance in fulfilling the receiver's duties and functions The FDIC as receiver has other important powers, as follows:

Legal Actions

After its appointment, the receiver may request a stay for a period not to exceed 90 days in any noncriminal judicial action or proceeding to which the Covered Financial Company is or becomes a party. To the extent an appealable judgment was rendered prior to its appointment, the receiver (i) has all the rights and remedies available to the Covered Financial Company, including appellate rights, and (ii) is not required to post a bond to pursue such remedies. The FDIC as receiver also has subpoena authority under the applicable section of the Federal Deposit Insurance Act, as if the Covered Financial Company were an insured depository institution.

In any action brought by the receiver, the applicable statute of limitations period is (i) in the case of a contract claim, the longer of six years from the date such claim accrues, or the applicable state law period, and (ii) in the case of a tort claim, the longer of three years from the date such claim accrues, or the applicable state law period. However, if the applicable state law statute of limitations with respect to a tort claim expired less than five years before the receiver's appointment, then the receiver may bring suit on such claim regardless of the expiration of such period.

Avoidable Transfers

The Wall Street Reform Act authorizes the receiver to avoid fraudulent and preferential transfers of any interest in property of, or obligation incurred by, the Covered Financial Company, pursuant to provisions similar to those in the U.S. Bankruptcy Code. In fact, the statute references the same definitions for the terms "insider" and "insolvent" and provides that a transferee or obligee subject to the receiver's avoidance powers has the same defenses as a transferee or obligee under sections 547, 548, and 549 of the Bankruptcy Code.

Claims Determination

The receiver must promptly publish and mail notice to the Covered Financial Company's creditors of a specified date by which to present claims, which date is not less than 90 days after the publication of such notice. A claim filed after the specified deadline will be disallowed unless (i) the claimant did not receive notice of the appointment of the receiver and (ii) the claim was filed in time to permit payment.

Under routine procedures, the receiver must decide within 180 days (which may be extended) after a claim is filed whether to allow such claim, and provide notice of its determination. A claimant may seek judicial determination of its claim by filing (or continuing) suit in the U.S. District Court for the District of Columbia or the district in which the company's principal place of business is located before the end of 60 days following the earlier of (i) the end of the 180-day period (or longer if extended) or (ii) the date of any notice of disallowance.

Under an expedited process for any claimant who (i) holds or controls a legally valid and enforceable perfected security interest in property or a specific asset of the Covered Financial Company and (ii) will suffer irreparable injury if the routine claims procedure is followed, the receiver must make its determination to allow or disallow (and provide notice of its decision) within 90 days following the date such claim is filed. A judicial review of such claim may be initiated following the end of the 90- day period.

Payments and Priorities

The receiver may pay on creditor claims in such manner and amounts as are authorized under the statute. Unsecured claims against the Covered Financial Company, or the FDIC as receiver for it, have priority in the following order:

  • Administrative expenses of the receiver
  • Amounts owed to the United States (unless the United States agrees otherwise)
  • Wages, salaries, or commissions of individuals (excluding senior executives and directors) earned not later than 180 days before the receiver's appointment, up to $11,725 (as adjusted for inflation)
  • Contributions to employee benefit plans (from services rendered not later than 180 days prior to the receiver's appointment)
  • Other general or senior liabilities of the Covered Financial Company
  • Any obligation subordinated to general creditors
  • Wages, salaries, or commissions owed to senior executives and directors of the Covered Financial Company
  • Equity interests

As part of its incidental powers, the receiver may obtain credit or incur debt on the part of the Covered Financial Company, which debt has priority over all administrative expenses.

The receiver may also, with the approval of the Secretary, make additional payments or credit additional amounts to any claimant if the receiver believes that such payments or credits are necessary or appropriate to (i) minimize losses to the receiver from the resolution of the Covered Financial Company, or (ii) prevent or mitigate serious adverse effects to the financial stability or economy of the United States.

Leases and Contracts

The receiver may generally enforce, assign, or disaffirm and repudiate any contract or lease.3 Any liability resulting from the disaffirmance or repudiation of any contract is (i) limited to actual, direct compensatory damages (which are separately set forth by type of contract) and (ii) determined as of the date of the appointment of the receiver, or in the case of Qualified Financial Contracts, as of the date of the disaffirmance or repudiation of such contract. With respect to a contract for services, if the receiver accepts performance by the counterparty prior to repudiation, such counterparty is to be paid under the terms of the contract for the services performed and such payment is treated as an administrative expense.

In the case of a lease where the Covered Financial Company is the lessee, the lessor: (i) is entitled to the contractual rent accruing before the later of (a) notice of disaffirmance or repudiation or (b) the effective date of disaffirmance or repudiation, unless the lessor is in default of the terms of the lease; (ii) has no claim for damages under any acceleration clause or penalty provisions; and (iii) has a claim for any unpaid rent, due as of the date of the receiver's appointment, less any setoffs and defenses.

Where the Covered Financial Company is the lessor, and the receiver repudiates such lease (and the lessee is not in default as of the date of such repudiation), the lessee may (i) treat the lease as terminated by such repudiation or (ii) remain in possession of the leasehold interest for the balance of the term of the lease, in which case the lessee (a) must continue to pay the contractual rent and (b) may offset any rent against damages due to the nonperformance of any obligation by the Covered Financial Company.

Similarly, where the receiver repudiates a contract for the sale of real property (and the purchaser is not in default), the purchaser may (i) treat the contract as terminated by the repudiation or (ii) remain in possession of such real property, in which case the purchaser (a) must continue making payments under such contract after repudiation and (b) may offset payments against any damages due to the nonperformance of the Covered Financial Company.

Bridge Financial Companies

The receiver may create, by charter, a bridge financial company as a vehicle in liquidating the Covered Financial Company. Such bridge financial company can (i) assume the rights, powers, and privileges; (ii) acquire liabilities and assets (which may include any trust or custody business and fiduciary appointments); and (iii) perform any other temporary function, of the Covered Financial Company.

Subject to certain limitations and restrictions, the receiver may transfer the assets and liabilities of, or merge a Covered Financial Company into, a bridge financial company without the need for approval under applicable federal or state law. Any judicial action to which a bridge financial company becomes a party, by virtue of its acquisition of any assets or assumption of any liabilities of a Covered Financial Company, is stayed for a period up to 45 days at the request of the bridge financial company.

A bridge financial company may also obtain credit and issue debt. Such debt may be secured by liens authorized by the FDIC, after notice and hearing, only if (i) the bridge financial company is otherwise unable to obtain such credit or issue such debt and (ii) there is adequate protection of the interest of any other holder of a lien on property with respect to which the proposed lien is to be granted.

A bridge financial company terminates at the end of the two-year period (which may be extended for three additional one-year periods at the discretion of the FDIC) following the date it was granted a charter, unless otherwise terminated upon the earliest of (i) the merger or consolidation of the bridge financial company with another company; (ii) at the election of the FDIC, the sale of a majority of the capital stock of the bridge financial company to another company; (iii) the sale of 80% or more of the capital of the bridge financial company; (iv) at the election of the FDIC, the assumption of all or substantially all of the assets of the bridge financial company by another company; or (v) the dissolution of the bridge financial company.

Liquidation Funding

Under the Wall Street Reform Act, an Orderly Liquidation Fund (the Liquidation Fund) will be established in the U.S. Treasury, which fund is available to the FDIC to cover its costs as receiver in carrying out the orderly liquidation of a Covered Financial Company. The Liquidation Fund will be funded by, among other sources, investments, and proceeds of obligations issued by the FDIC to the Secretary (the Fund Obligations).

In addition, the FDIC may impose graduated risk-based assessments as is necessary to repay the Fund Obligations within five years following the issuance of such Fund Obligations, on any claimant that received additional payments from the receiver to recover the difference between what such claimant received and what the claimant would have been entitled to receive solely from the liquidation of the Covered Financial Company, and, if the cumulative recoveries from such claimants are insufficient to repay the Fund Obligations, Financial Companies with total consolidated assets equal to or greater than $50 billion and nonbank financial companies supervised by the Board.

Ban Against Certain Individuals

In addition to the authority and mechanics of an orderly liquidation of a Covered Financial Company through a receivership under the FDIC, section 213 of Title II sets forth a ban against certain senior executives or directors from participating in the affairs of any Covered Financial Company.

Specifically, if the Board or FDIC, as applicable, determines that (i) a senior executive or director of a Covered Financial Company has (a) violated any law or regulation, or any order or condition of a federal agency, (b) engaged in any unsafe or unsound practice (in connection with any Financial Company), and (c) breached such executive's fiduciary duties; (ii) that such senior executive or director received financial gain and contributed to the failure of the company by reason of the violation, breach or practice; and that (iii) such violation, practice or breach involves personal dishonesty, or demonstrates willful disregard for the safety and soundness of the company, then such senior executive or director may be prohibited from any participation in the conduct of the affairs of any Financial Company for a period of not less than two years.

President's proposed legislation

Title XII Enhanced Resolution Authority

This Act may be cited as the “Resolution Authority for Large, Interconnected Financial Companies Act of 2009”.

Source: Resolving Resolution: The Insolvency of Important Financial Institutions Dewey & LeBoeuf, August 18, 2009

"Roughly speaking, the proposed new tools would permit the government to:

  • Intervene prior to an institution's insolvency;
  • Provide many different types of financial support, including guarantees;
  • Delay the settlement of swaps; and
  • Exercise a generalized version of the resolution powers currently available to the Federal Deposit Insurance Corporation (the "FDIC") when insured depository institutions fail.

The Resolution Act accomplishes this by defining the business entities subject to the Act, specifying which federal agency is responsible in the various possible cases, and using the existing resolution authority of the FDIC as a template to be modified for broader application.

Significantly, the Resolution Act does not apply automatically when the applicable type of financial institution is in difficulty. The government must first determine that the specific situation warrants application of the Act.

The Entities Subject to the Act

The entities subject to the Resolution Act are referred to as bank holding companies, but include both so-called Tier 1 financial holding companies, as well as ordinary bank holding companies. Despite the potential confusion, both types of companies will be called bank holding companies in this Client Alert. Subsidiaries of both types of companies are also included, other than

  • (i) broker-dealers that are registered with the Securities and Exchange Commission ("SEC") and are members of the Securities Investor Protection Corporation ("SIPC"), and
  • (ii) domestic insurance companies, within the meaning of the Bankruptcy Code. In addition, institutions that are bank holding companies or their subsidiaries for purposes of the Resolution Act must be organized or incorporated under US state or federal law.

Given this set of definitions, even a foreign corporation with most of its activities in the US would not be subject to resolution under the Act, although a US subsidiary of a foreign corporation would, so long as it is neither a domestic insurance company nor a broker dealer that is a member of SIPC.

A foreign subsidiary of a bank holding company being resolved under the Act is apparently affected by the Act to some extent (despite the requirement that entities subject to the Act be incorporated or organized in the US), since Section 1209(a)(1)(M) of the Act requires to "coordinate with the appropriate foreign financial authorities regarding the resolution of subsidiaries of the covered bank holding company that are established in a country other than the United States."

However, such a foreign subsidiary may not receive financial assistance under the Act. Because the Resolution Act excludes domestic insurers only as subsidiaries of bank holding companies and Tier 1 financial holding companies, it is unclear how the Act intends to treat any insurance company that is itself a bank holding company. A similar lack of clarity exists with regard to SIPC members that are themselves bank holding companies or Tier 1 financial holding companies, although the practical likelihood of such a company existing seems quite low.

Invoking the Resolution Act

The Act does not automatically apply to bank holding companies. Its application must be invoked by the Secretary of the Treasury (in consultation with the President) upon the recommendation of the Federal Reserve Board and either the FDIC or the SEC. The SEC plays this role only if the bank holding company or its largest subsidiary (measured by assets) is a broker-dealer, without any consideration of whether the actual resolution of the holding company or its subsidiary would be excluded from the application of the Resolution Act because the relevant corporation is a member of SIPC. The Secretary is not required to follow any recommendation that is submitted. In addition to considering any recommendation, the Secretary must determine that

  1. The bank holding company is in default or is in danger of default;
  2. The failure of the bank holding company and its resolution under otherwise applicable Federal or State law would have serious adverse effects on financial stability or economic conditions in the United States; and
  3. Any action or assistance under [the section relating to financial assistance and the appointment of a conservator or receiver] would avoid or mitigate such adverse effects, taking into consideration the effectiveness of action or assistance in mitigating potential adverse effects on the financial system or economic conditions, the cost to the general fund of the Treasury, and the potential to increase moral hazard on the part of creditors, counterparties and shareholders in the bank holding company.1

Applying the Resolution Act

The Act contemplates that the powers it grants may be applied in two different ways. Whichever agency (the FDIC or the SEC) acts as conservator or receiver will apply the provisions of the Act to the assets and obligations of the endangered bank holding company (other than its excluded subsidiaries). In addition, the FDIC is independently empowered to provide financial assistance to the bank holding company or in aid of its resolution (i.e., presumably to someone else) by making loans, purchasing debts or assets, assuming or guaranteeing obligations, and contributing equity. This independent power most likely reflects the SEC's lack of financing capabilities.

No mechanical procedures are established for coordinating any financing by the FDIC with any administrative acts by the SEC. It is therefore unclear who would have the authority to resolve disputes between the two agencies, unless the Secretary of the Treasury has such power ex officio.

Both the SEC and the FDIC, however, would have the power to arrange priority funding from third parties for bridge bank holding companies that may be established in the course of resolving the financial problems of a bank holding company.

"... As with any new proposal, the first and most central questions are: how would this work? How would it be different than what is possible today? So let me close with a brief overview of how these authorities could come together if the U.S. government were once again faced with situations like those of last September.

First, firms would have prepared a "living will" embodying a resolution strategy. Second, such firms would have large capital buffers in the event of failure, and stringent conditions imposed on the use of "hot" money funding. Regulators would have the authority to supervise the firm for system-wide risks and to impose tough prudential measures. 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 major firms fail, and prudential measures and capital buffers prove inadequate such that bankruptcy is not an option, special resolutions should be available.

A conservatorship or receivership under this authority would have four essential elements that would improve execution and outcomes relative to the tools that were available last fall:

  • (i) swifter replacement of board and senior management with new managers selected by the FDIC;
  • (ii) a temporary stay of counterparty termination and netting rights to mitigate the adverse consequences to the company's liquidity, avoiding the cross defaults and cascades that otherwise, create a vicious cycle leading ultimately to financial collapse;
  • (iii) the ability to provide the firm with secured financing to fund its liquidity and capital needs during the conservatorship or receivership to mitigate the "knock on" effects of any firm's failure and to fund its operations, pending its sale or winding down.; and
  • (iv) the creation of one or more bridge bank holding companies in the case of a receivership to preserve the business franchise, deal with counterparty claims, and protect viable assets of stronger subsidiaries pending their sale. This would end the firm – wind it down – without contributing to system-wide failure.

In 1933, following an uncomfortably familiar chain of events, the failure of one bank bred panic and market disruption so great that Congress sought to insure that such events would not be repeated. In its wisdom, Congress created the FDIC and endowed it with the authority to resolve troubled banking institutions with the swiftness necessary to maintain the stability of the financial system of the time. Again in the wake of the thrift and bank failures of the late 1980s, Congress enacted reforms to enhance the FDIC's ability to manage the unprecedented scale, scope and complexity of modern bank failures. Our proposal does little more than apply to covered bank holding companies, under rare circumstances, the same model that Congress has developed, that the FDIC has executed, and that courts have respected, over the course of more than three-quarters of a century.

Our proposals represent a comprehensive, coordinated answer to the moral hazard challenge posed by our largest, most interconnected financial institutions: strong, accountable supervision; the imposition of costs, both to deter excessive risk and to force firms to better protect themselves against failure; a strong, resilient, well-regulated financial system that can better absorb failure. The proposals for resolution authority borrow from established law and practice and are narrowly tailored to the extraordinary needs of the financial system and the economy during periods of crisis. The plan protects taxpayers and enables shareholders and creditors to take losses.

Together, these proposals give us a clear and credible argument that, as the President said two weeks ago in New York, "Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall."

Congressional lawmaking

Congress approves new resolution authority

One of the glaring problems exposed by the recent financial crisis has been the absence of supervisory authority to deal effectively with the insolvency or collapse of significant, nonbank financial companies.

While bank regulators have long been empowered to close and liquidate insolvent banks to protect the public, there was no comparable authority vested in any financial services regulator to close and liquidate insolvent bank holding companies or other kinds of financial companies. To make matters worse, when several systemically important financial companies were on the verge of collapse in September 2008, they were deemed “too big to fail” and given significant government assistance.

Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) addresses the absence of regulatory authority to liquidate systemically important, nonbank financial companies by creating an “orderly liquidation authority” (“OLA”) process to allow the Treasury Secretary to close and the Federal Deposit Insurance Corporation (“FDIC”) to wind up these companies.

To view the complete alert online, click here.

H.R. 4173 Section 1701

(1) IN GENERAL- In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, upon the written determination, pursuant to section 1109 of the Financial Stability Improvement Act of 2009, of the Financial Stability Oversight Council, that a liquidity event exists that could destabilize the financial system (which determination shall be made upon a vote of not less than two-thirds of the members of such Council then serving), and with the written consent of the Secretary of the Treasury (after certification by the President that an emergency exists), may authorize any Federal reserve bank, during such periods as the Board may determine and at rates established in accordance with the provision designated as (d) of section 14, to discount for an individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal reserve bank and in conformance with regulations or guidelines issued by the Board of Governors regarding the quality of notes, drafts, and bills of exchange available for discount and of the security for those notes, drafts and bills of exchange, unless a joint resolution (as defined in paragraph (5)) is adopted.

Upon making any determination under this paragraph, with the consent of the Secretary of the Treasury, the Financial Stability Oversight Council shall promptly submit a notice of such determination to the House of Representatives and the Senate. The amounts made available under this subsection shall not exceed $4,000,000,000,000.

Financial Stability Improvement Act of 2009 (House draft)

On Friday, the House Committee on Financial Services continued its mark-up of the Financial Stability Improvement Act of 2009. For the most part, the amendments considered were relatively non-controversial. The Committee’s mark-up sessions are scheduled to resume tomorrow.

The Committee passed an amendment offered by Chairman Barney Frank (D-MA) designed to ensure that systemically important institutions are only publicly identified when restrictions are simultaneously imposed upon those institutions. The amendment was widely supported as an alternative to creating a list of systemically important firms, a requirement that many Committee members opposed.

The Committee also passed a second amendment offered by Chairman Frank that would moderate the power wielded by the Federal Reserve in proportion to powers delegated to other regulators. The amendment would require that the Board of Governors of the Federal Reserve “consult with other Federal financial regulatory agencies” when creating standards that are likely to have a “significant impact on a functionally regulated subsidiary” of a financial holding company.

Several minor amendments were also adopted dealing with issues ranging from reporting requirements of the Financial Services Oversight Counsel to protection of employees in the event of the merger of the OCC and OTS.

A Republican amendment in the nature of a substitute to the Committee draft is currently pending but is not expected to pass the Committee. The Republican amendment would, among other things, amend the bankruptcy code to allow for the unwinding of financial institutions through bankruptcy and amend the Federal Reserve’s emergency powers under Section 13 of the Federal Reserve Act.

When the Committee resumes the mark-up on November 17, 2009, further amendments are expected to primarily concern the powers granted to the Federal Reserve under the Act and which companies would be subject to the Act.

FDIC chair argues for winddown authority

"...Both the already passed House bill, as well as the bill approved by the Senate Banking Committee, draw on the FDIC model to create a resolution authority that specifically applies to large, complex nonbank financial firms. Under both bills, bankruptcy would be the normal process. But under extraordinary procedures, the government would have the option to put the very largest firms into an FDIC-style liquidation process if necessary to avert a broader systemic collapse.

As with banks, the legislation would allow the FDIC to create a temporary institution in order to allow continuity and prevent a systemic collapse while the firm is being liquidated. To provide working capital for this bridge, both bills would require the largest financial firms to pay assessments in advance so that taxpayers would not be at risk. The firms that pose the most risk would pay the most. This orderly liquidation process—funded by the firms themselves—would, for the first time, force these institutions to internalize the full costs of the risks they create.

The FDIC process can also facilitate pre-planning and international cooperation when a large, global financial entity gets into trouble. Given the conflicting bankruptcy regimes throughout the world, there is growing international consensus that we need a special liquidation process available as an alternative. Great Britain and the European Union are both seeking to construct special resolution mechanisms. The U.S. should draw on the FDIC's long experience and lead the way..."

New bankruptcy chapter for non bank institutions "Chapter 11F"

Fortunately, it is not necessary to provide this additional discretionary authority. During the past year since the administration proposed its financial reforms, bankruptcy experts have been working on a reform to the bankruptcy law designed especially for nonbank financial institutions. Sometimes called Chapter 11F, the goal is to let a failing financial firm go into bankruptcy in a predictable, rules-based way without causing spillovers to the economy and permitting, if possible, people to continue to use its financial services—just as people flew on United Airlines planes, bought Kmart sundries and tried on Hartmax suits when those firms were in bankruptcy.

What would a Chapter 11F amendment look like? It would create a special financial bankruptcy court, or at least a group of "special masters" consisting of judges knowledgeable about financial markets and institutions, which would be responsible for handling the case of a financial firm.

In addition to the normal commencement of bankruptcy petitions by creditors or debtors, an involuntary proceeding could be initiated by a government regulatory agency as prescribed by the new bankruptcy law, and the government would be able to propose a reorganization plan—not simply a liquidation. Defining and defending the circumstances for such an initiation—including demonstrating systemic risk using quantitative measures such as interbank credit exposures—is essential.

Third, Chapter 11F would handle the complexities of repurchase agreements and derivatives by enabling close-out netting of contracts in which offsetting credit exposures are combined into a single net amount, which would reduce likelihood of runs.

Fourth, a wind-down plan, filed in advance by each financial firm with its regulator, would serve as a blueprint for the bankruptcy proceedings.

The advantage of this bankruptcy approach is that debtors and creditors negotiate with clear rules and judicial review throughout the process. In contrast, the proposed "orderly liquidation" authority in the current bill is secretive and potentially capricious. Rather than a government official declaring "we will wipe out the shareholders" or "it's unfair for us to claw back so much from creditors," under Chapter 11F the rule of law applies.

A discretionary punishment can be just as harmful as a discretionary bailout. As George Shultz puts it in the book "Ending Government Bailouts As We Know Them," recently published by the Hoover Press, "Let's write Chapter 11F into the law so that we have a credible alternative to bailouts in practice."

What are the obstacles to following this sensible advice? One is that the proposals are new; much of the creative work was done in the past year since the administration first made its reform proposals. A common perception is that bankruptcy is too slow to deal with systemic risk situations in a large complex institution, but the new proposals would have a team of experts ready to go.

Another obstacle is that the Judiciary Committee rather than the Banking Committee has jurisdiction over bankruptcy law, and it is too hard to coordinate. But bureaucratic silos should not get in the way when the stakes are so high.

Chairman Frank withdraws support for prepaid resolution fund

Representative Barney Frank said on Monday that securities regulators' fraud case against Goldman Sachs increases the chance that financial reform will pass.

Frank, chairman of the House Financial Services Committee, also said he does not believe all 41 Republicans in the Senate will vote against the financial reform bill.

"It reinforces the need for much of what we were doing" on financial reform, Frank said on CNBC Television. On Friday, the U.S. Securities and Exchange Commission charged Goldman with fraud for its marketing of a subprime mortgage product.

Frank also said it is not essential to create a standing fund of capital to dismantle troubled financial firms, responding to Republican objections that it would amount to a bailout fund.

Senate discusses $50 billion prepaid resolution fund

Senate negotiators are closing in on a deal to create a $50 billion trust fund from fees on large U.S. financial firms that likely will include Goldman Sachs Group Inc. and Citigroup Inc. and be used to wind down failing institutions, said a Senate aide and two people familiar with the talks.

Senator Mark Warner, a Virginia Democrat, and Senator Bob Corker, a Tennessee Republican, are near agreement to create a mechanism that will dissolve companies in an orderly way without using taxpayer funds, according to two Senate aides who declined to be identified yesterday because the talks are private. Treasury Secretary Timothy Geithner met Warner and Corker yesterday to discuss the overhaul negotiations without reaching a deal, said a person familiar with the meeting.

An agreement on the powers to shut large institutions would remove one of several roadblocks that have stalled Senate negotiations on the overhaul legislation. A final agreement hasn’t yet been reached on the resolution powers, or on the broader measure, the aides said.

The House in December passed legislation that created a larger, $150 billion fund, to avoid taxpayer bailouts, such as the rescue of American International Group Inc. in 2008. The measure would give the government power to prop up non-bank firms, the authority regulators said they lacked when Lehman Brothers Holdings Inc. filed for bankruptcy in 2008.

The Federal Deposit Insurance Corp. would get primary responsibility for managing the shutdown of a systemically risky firm on the verge of failure, the people said.

Fed, Treasury Role

The Senate compromise would give the Federal Reserve the power to decide which firms would pay into a trust fund that would be held and managed by the Treasury Department, according to a person familiar with the matter. Banks deemed to be a systemic risk would pay into the fund, and the firms could earn interest, the person said. The trust would be structured to avoid altering a company’s earnings or capital levels, the person said.

Should a systemic firm fail, Treasury would transfer cash from the $50 billion fund to the resolution authority to cover any costs to shut the firm. The FDIC then could assess the banking industry for any losses incurred by the trust fund, the person said.

The committee also is considering a proposal that would require regulators to consult with a bankruptcy court before acting against a failing firm, according to people familiar with the matter. If the court approved, Treasury would appoint the FDIC as the receiver.

Geithner Proposal

Geithner last year proposed assessing a wind-down fee on financial firms after an institution failed. Geithner, in testimony to the House Financial Services Committee, said on Oct. 29 that paying in advance would create “moral hazard” by signaling to companies cash was available in the event of a failure. House Democrats said the banking industry should be forced to pre-pay for any failures.

House Republicans have objected to any prepaid fund, saying it would create a “permanent bailout authority.” FDIC Chairman Sheila Bair has backed a prepaid fund so that shareholders and creditors bear any losses, not taxpayers.

Senate negotiators, led by Banking Chairman Christopher J. Dodd, a Connecticut Democrat, and Corker have been in negotiations for the past three weeks that Dodd said are tedious and fragile.

“I can tell you very candidly, it’s very delicate and this thing could trip easily,” Dodd told reporters yesterday.

Experts say bills won't end "too big to fail"

We at Planet Money did an informal survey of economists and regulatory experts on the left and the right. We couldn't find any who fully endorse the reforms backed by President Obama and Democrats in Congress.

Everyone thinks the reforms just aren't enough to solve the problem.

Take, for example, "too big to fail" -- the idea that if one of the largest banks in the country gets into trouble, the government will save it with taxpayer money.

"A vote for reform is a vote to put a stop to taxpayer-funded bailouts," Obama said in his speech in New York on Thursday.

I cannot find any experts -- of any party -- who are willing to agree with Obama on this one.

"We're not seeing a very forceful step on the too-big-to-fail-problem," said Carmen Reinhart, an economist at the University of Maryland. "If there's any doubt that the crisis may be systemic, we will bail out again."

So, if a major bank says, "Hey, save us or the economy will go under," the government's going to save the bank. Full stop.

We did find one expert, Doug Elliott of the Brookings Institution, who is actually a huge fan of the regulatory reform bills. He says they bring a bunch of changes that make our economy safer.

But they don't end too big to fail, he said. The only way to do that is to break them up so that "they're so small that we don't care" if they fail.

This is close to a consensus view among the experts. Some say that's a good idea, some say it isn't. But most say that unless you chop up the big banks into lots of small banks, you won't end too big to fail.

Barclays analysis of resolution on bondholders

You can see that, in BarCap’s opinion, Bank of America and Citigroup will be most affected, with, interestingly, the possibility of ratings downgrades “if resolution authority passes.” Resolution authority being the ability to place any large financial co. into conservator- or receivership. To date, the US government has only really been able to do one of two things for bailed banks; allow them to go bankrupt, or bail them out.

Here’s a bit more detail from the BarCap analysts:

If the regulators gain this right, bondholders will be at greater risk because they will no longer benefit from the government’s unwillingness to allow a destabilizing bankruptcy and the capital infusions that usually prevent it. Rather, resolution authority will be used, which carries much greater risk for bondholders. We note that in the House bill, unsecured creditors must take losses if the resolution process begins. Because of this, we believe passage of financial reform into law could lead to lower ratings for systemically important financial companies. Currently, many financial companies are rated higher than their fundamentals justify because the rating agencies believe systemic support is likely. If systemic support includes losses for bondholders, then this rating “uplift” could be eliminated, in our opinion.

Goldman Sachs and Morgan Stanley are also rather affected — not because of their proprietary trading — but because of their reliance on the repo market for funding, and the impact the Financial Reform bill is expected to have on that market (which is, incidentally, something we’ve heard before from BarCap):

The House Bill also has an amendment that we believe has important implications for secured creditors and for financial institutions that rely on secured borrowings. The amendment allows up to 10% of a secured claim to be treated as an unsecured claim, regardless of the value of the collateral securing the debt. The provision would encompass fully secured creditors with an original term of 30 days or less secured by collateral other than Treasuries, agencies, or real estate. Essentially, repurchase agreements, in our opinion. As shown in Figure 7, many large financials, particularly those that operate capital markets businesses, still rely on the repo market for funding. We believe repo would become less available and less stable if this amendment becomes law, making it more difficult to carry trading inventory. Again, the secured funding amendment is not included in the Senate bill.

S.1540 - Proposed FDIC resolution authority

A bill to provide for enhanced authority of the Federal Deposit Insurance Corporation to act as receiver for certain affiliates of depository institutions, and for other purposes.

Source: Senators' proposal would empower FDIC AP, July 31, 2009

"Two senators are pushing legislation that would give the Federal Deposit Insurance Corp. unilateral power to dismantle bank holding companies on the brink of collapse but not take them over on behalf of the government.

A bill introduced Thursday by Sens. Mark Warner, D-Va., and Bob Corker, R-Tenn., suggests that rank-and-file members in Congress want a chance to weigh in on what will become the biggest overhaul to financial regulations since the 1930s.

It also suggests a sense of urgency among lawmakers to fix a failed regulatory framework as more bank failures remain a possibility even as the economy shows signs of struggling back to health.

"The calendar is slipping ... and the fact of the matter is, we're still not out of the woods yet," Corker said in an interview.

The FDIC already can dismantle banks and the deposit-taking subsidiaries of bank holding companies. But it has been powerless when it comes to safely winding down the rest of a bank holding company, even if its failure could devastate the economy.

The Obama administration has recommended expanding the FDIC's power to allow the agency, with the president's blessing, to put a bank-holding company in conservatorship -- an arrangement similar to the government takeover of mortgage buyers Freddie Mac and Fannie Mae.

Warner and Corker's measure would allow the FDIC only to liquidate firms.

Corker said this approach would prevent the government from taking over and propping up financial institutions, exposing taxpayers to the possibility of having to foot the bill. The FDIC funds most of its activities by collecting premiums from banks for insuring their deposits.

Corker and others want to end the "too-big-to-fail" approach that regulators adopted in rushing in with government funds to rescue several large institutions in the heat of the last year's financial meltdown.

Paving the way for more bailouts "is not well received by members of any party," Corker said.

Sheila Bair has asked Congress for immediate authority for the FDIC to take over and resolve bank holding companies. She has received a sympathetic response from several lawmakers, who approve of Bair's approaches and the FDIC's activities during the financial tumult while being openly distrustful of the Federal Reserve.

Scores of bank holding companies, such as Citigroup Inc. and Bank of America Corp., now fall under the Federal Reserve's supervision."

Special bankruptcy court for banks mulled in U.S. Senate

Key U.S. senators are considering the creation of a special bankruptcy court for troubled financial services firms, a person familiar with the plans said on Monday.

Senate Banking Committee members are trying to toughen up parts of a draft bill that overhauls how the financial system is supervised. The draft, introduced by Senate Banking Committee Chairman Christopher Dodd, would create a system to unwind troubled financial firms.

But members of the committee want a more specific and tougher regime to deal with troubled financial firms after the federal government used billions of dollars in taxpayer funds to prop up firms like Bank of America.

Members are discussing a two-stage process that would create a preferential option for bankruptcy followed by a regulator-managed resolution if bankruptcy fails, the person said. The source requested anonymity because the draft is in flux and has not been made public.

Dodd’s proposal would give the Federal Deposit Insurance Corp the authority to dismantle large troubled financial services firms. The FDIC would be able to guarantee debts of firms in receivership.

Some committee members want to craft stricter laws to make sure that the first option for a troubled firm is bankruptcy, the source said. Members also want a system to ensure that counterparties, creditors and shareholders share in the loss if the firm fails, said another person familiar with the plan.

“We’re looking at a bankruptcy concept, a receivership. We’re going to make resolution a very painful process if we go that route and that’s going to be a major step forward with this bill,” Dodd told CNBC TV.

Dodd plans to retire from the Senate by the end of the year but has said he is committed to reforming the country’s financial regulation.

His bill has not been well received by Republicans on the Senate Banking Committee. Now lawmakers from both parties are trying to find consensus on how to regulate everything from banks to executive compensation.

The House of Representatives passed an extensive financial reform bill last year. The House bill gives the FDIC the authority to dismantle insolvent firms through bankruptcy or receivership much like it dismantles failing banks now.

Dodd and Richard Shelby, the top Republican on the Senate Banking Committee, have said they hope to reach a deal on financial reform before the Senate reconvenes on Jan. 20.

Any potential Senate bill would have to be reconciled with the House bill before the president could sign it into law.

Shelby goes public in support of 'resolution authority'

"Democrats’ best hope for passing the biggest overhaul of the nation’s financial laws since the Great Depression may rest with an unpredictable, anti-bailout conservative who’s skeptical of Big Government.

But Sen. Richard Shelby (R-Ala.) is a deal maker, and he’s looking more and more like he’s ready to compromise — regardless of whether his party leaders want to slow walk a Democratic priority.

Shelby, the top Republican on the Banking Committee, is backing a White House proposal to grant the federal government the broad power of “resolution authority” to wind down complex financial institutions rather than bail them out. He hasn’t shut the door to the creation of a consumer financial protection agency — something that many Republicans have flatly dismissed as another government bureaucracy. Shelby has also endorsed a federal crackdown on the private bond rating agencies that gave high marks to shoddy investment products.

And he even sounds open to merging bank oversight into a federal super-regulator — something he says is “on the table” even though, he admits, the idea needs a lot more study.

All this bucks the conventional wisdom that financial reform is too complex and too divisive to happen anytime soon. And with Shelby backing a major bill, it would also give Democrats bipartisan cover to force the overhaul through the Senate.

“This will be the next big thing, and that’s why I’ve worked all year on this very, very hard,” Shelby said in an interview with POLITICO.

Financial industry officials also speculate that Shelby, 75, is keen to secure his senatorial legacy by being a linchpin on legislation that will set the course for Wall Street regulation for decades. And that’s why he’s been quietly negotiating financial reform with Banking Committee Chairman Chris Dodd (D-Conn.).

Shelby has hired five new Banking aides since June — serious policy types — and the move is being interpreted by key observers as another sign Shelby is committed to achieving a financial reform bill.

“You don’t do that if you’re not interested in getting something done,” said one financial services industry executive.

Dodd, who has faced Shelby’s wily negotiating style on dozens of bills over the years, remains optimistic. “His word is very good, which is absolutely critical. ... When he’s against things, he tells you,” Dodd said. “He’s very clear; that’s what I love about him.”

By compromising with Dodd on several fronts, Shelby may also gain some leverage in pushing a conservative priority: reining in the Federal Reserve.

“The Federal Reserve as a regulator — it certainly hasn’t been their best day,” Shelby said. “As a matter of fact, a lot of us are not enamored with the results of the Federal Reserve as a regulator.”

But even as he frames himself as the deal maker, Shelby remains skeptical on several key issues.

A harsh critic of the $700 billion Troubled Asset Relief Program, Shelby is unhappy with how the money has been handled, and he wants more oversight. But his opposition to bailouts is also why he supports the need for a quick resolution authority.

“Look at [AIG|American International Group]. AIG was taken over a year ago. They still don’t have their hands around AIG. It’s costing a lot of money, and what’s the resolution to it? We need to dispense with it,” he said...."

House hearing September 24, 2009

Thursday, September 24, 2009, 2128 Rayburn House Office Building

Click Here To View Archived Webcast

Witness List & Prepared Testimony:

  • The Honorable Paul Volcker, Former Chairman of the Board of Governors of the Federal Reserve System Testimony
  • The Honorable Arthur Levitt, Jr., Former Chairman of the United States Securities and Exchange Commission, Senior Advisor, The Carlyle Group, Testimony
  • Mr. Jeffrey A. Miron, Senior Lecturer and Director of Undergraduate Studies, Department of Economics, Harvard University, Testimony
  • Mr. Mark Zandi, Chief Economist, Moody’s, Testimony
  • Mr. John H. Cochrane, AQR Capital Management Professor of Finance, The University of Chicago Booth School of Business, Testimony

GOP's proposed resolution authority

Source: GOP's Financial Regulation Alternative Would End Too Big To Fail Policy Reason Foundation, July 23, 2009

Obama Plan: Creates a resolution authority to nationalize failing non-bank financial institutions in order to prevent systemic damage; funding for the resolution authority is yet to be determined by Congress; failing banks will still be protected by the FDIC.

GOP Plan: Amends bankruptcy laws to create new Chapter 14 bankruptcy proceedings for non-bank financial institutions that would build on Chapter 11 bankruptcy by expediting the hearing process; failing banks will still be protected by the FDIC.

Commentary: The real debate here is whether firms should be considered too big or interconnected to fail. The Obama plan believes this is unavoidable and seeks to create a system to handle non-bank firms that might need bailouts. This authority would have been used for AIG, Bear Stearns, or Morgan Stanley had they technically failed. The Chapter 14 proposal from the GOP believes that firms should be allowed to fail and then get resolved through the bankruptcy system."

US regulatory approaches

"Contingency planning" considered best option

The idea of requiring giant banks to develop contingency plans that would spell out their orderly demise in a financial crisis gained support on Thursday from major international regulators.

The Basel Committee on Banking Supervision, a forum for international cooperation on financial regulation, endorsed the idea, while Lawrence H. Summers, the director of the National Economic Council, and Daniel K. Tarullo, the Federal Reserve governor who oversees the central bank’s regulatory duties, spoke in favor of it.

The endorsements come as the Senate debates a sweeping overhaul of financial regulation aimed, among other things, at buffering the economy from the kind of systemic threats that companies like Lehman Brothers and the American International Group posed in 2008.

But it is not clear whether such contingency plans, also known as living wills, will be worth more than the paper they are written on.

FDIC chief suggests limiting secured claims to 80%

Federal Deposit Insurance Corp Chairman Sheila Bair told a group of international bankers on Sunday that officials might want to consider “the very strong medicine” of limiting secured claims to 80 percent, although she said such a proposal would need to be carefully weighed.

She said curbing claims would encourage secured creditors, who are protected from losses when a bank fails, to more closely monitor the risks a bank is taking and could speed up the process when an institution needs to be wound down.

"This could involve limiting their claims to no more than say 80 percent of their secured credits. This would ensure that market participants always have ’skin in the game’,” Bair told a meeting of the Institute of International Finance here.

While Bair said the far-reaching proposal could have a “major impact” on the cost of funding for banks subject to any official resolution mechanism, it also had advantages.

“A major advantage is that all general creditors could receive substantially greater advance payments to stem any systemic risks without the extensive delays typically characteristic of the bankruptcy process,” she said.

“Obviously, the advantages and disadvantages need to be thoroughly vetted. In any event, there is a serious question about whether the current claims priority for secured claims encourages more risky behavior,” Bair added.

The U.S. Congress is currently considering wide-ranging regulatory reforms that would give regulators the authority to “resolve” — or wind down — systemically important non-bank institutions. The FDIC already has such authority for deposit-taking banks.

Bair said officials around the world should consider resolution regimes that cover both banks and non-bank operations of financial conglomerates, whether or not their failure might spark wider troubles for the financial system.

She said resolution authority should include the ability to reject “burdensome” contracts, sell assets, resolve claims, and establish and operate bridge financial companies.

Repo, collateral demands under the Bankruptcy Abuse Prevention Act

While much is being made of Sheila Bair’s recent comments on haircuts to secured lenders, the Chair of the FDIC seems, to me, to be trying to expand the discussion of problem bank resolution in a constructive manner. Other regulators, so far, have shied away from real policy reforms that deal with too-big-to-fail in any meaningful economic sense. The FDIC, however, is trying to eviscerate some old policies that have been more and more troublesome with each passing crisis and at the same time lay down some resolution principals that can carry over to the next crisis. Let’s take a hard look at what she may really be proposing in more detail.

Recall that Bloomberg reported yesterday that, Federal Deposit Insurance Corp. Chairman Sheila Bair said regulators should consider making secured creditors carry more of the cost of bank failures. “This could involve potentially limiting their claims to no more than, say, 80 percent of their secured credits,” Bair said in a speech to a banking conference in Istanbul [on October 4]. “This would ensure that market participants always have some skin in the game, and it would be very strong medicine indeed.” …Bair, while acknowledging her proposal could increase borrowing costs for banks, said it might encourage them to reduce their reliance on short-term funding while making the broader financial system more resilient. She also said it might reduce the burden of a failure on unsecured creditors, who would then be less likely to press for a government bailout. (Rebecca Christie, “Bair Says Secured Creditors Should Help Pay for Bank Failure,” 2009-10-05 02:18:31.923 GMT)

While the Bloomberg piece was in introduction to the debate, in order to properly understand the weight of Ms. Bair’s remarks, you really have to understand the dynamics of the meltdown. Few people, however, still understand what happened in the grander scheme.

In the years leading up to the crisis there was a growing reliance upon market funding the entire mortgage origination pipeline, taking the entire operation off of many bank balance sheets, just as non-bank “mortgage bank” monoline (non-bank bank, not financial guarantors) financial institutions worked without that balance sheet to begin with.

The idea became to finance short-term day loans to lenders on a daily basis, which were repaid upon selling the loans into several-week repo commitments as longer-term warehousing and, later, monthly securitizations as more permanent funding. The short story of the crisis is that securitization was evaporating all through 2007 leading to increased margin calls on repo warehouse funding, and the eventual shutdown of day loans at various times (depending on which institution you are talking about) before Lehman, with Lehman marking the end of the road for everyone.

The key to the arrangements was increased acceptance of repo funding by commercial banks and other mortgage originators, as well as bankruptcy courts, in the past decade. In an April 22, 2009 Viewpoint piece written for Dow Jones DBR Small Cap, Julia Whitehead explains succinctly:

…the measures now causing so much distress for the industry were rooted in a desire to protect markets from the snowballing impact of the bankruptcy of a large player. Back in 1978, when the Bankruptcy Reform Act modernized Chapter 11, the initial expression of this concern was limited to protecting pre-bankruptcy margin payments on commodity transactions from clawback by a debtor's estate.

…By 2005, the enormous growth of financial markets, particularly those involving complex swaps and derivatives which had never experienced the bankruptcy of a big counterparty, caused industry leaders to grow queasy that a filing by a large enough player could cause systemic damage. By that time also, the conclusion that counterparties' ability to close out their exposures to Long-Term Capital Management had saved the market from the collapse of that firm was gaining traction. The convergence of those thoughts propelled BAPCPA's extension of safe harbor provisions to a seemingly unlimited universe of financial contracts and dramatically increased the number of parties who could freely terminate or accelerate agreements, liquidate positions, and set off claims against margin or collateral called in from a debtor without fear of interference by a bankruptcy court. BAPCPA provided new powers as well through its inclusion of the so-called "master netting agreement", which allowed counterparties to exert all these bankruptcy- protected actions across multiple contracts and products, a response to the belief that the more players were able to net down their all exposures free of Chapter 11 constraints, the less exposed they and the markets would be to travails of a major participant.

…American Home Mortgage's bankruptcy illustrated some of these problems. The firm filed after failing to meet the second of two margin calls from Lehman under a master repurchase agreement secured by mortgage-backed securities which were foreclosed on by Lehman after the bankruptcy filing. American Home subsequently argued that not only were the margin calls fabricated (their own valuation of the mortgage securities being substantially higher than Lehman's), but that the repo was really a secured lending agreement with some extra language thrown in simply to allow Lehman to take advantage of BAPCPA's safe harbor protections for repo agreements.

…It is no surprise, even, that the totality of these demands could completely overwhelm whatever liquidity reserves a hapless company thought it would need to cover the most draconian calls, and helped to push Bear Stearns and AIG into government-assisted rescues and Lehman Brothers right through the Chapter 11 door.

…While once firms moderated their collateral demands lest they individually or collectively push a weak counterparty into a bankruptcy that could pull back that collateral and take years to resolve, with BAPCPA's safe harbors, counterparties are incentivized to grab whatever they can as fast as they can; if they don't someone else surely will and who wants to be the only one fighting it out as an unsecured creditor in Chapter 11? [emphasis added]

So what the FDIC is struggling against is really a violation of absolute priority, memorialized by BAPCA, that puts traditional bank assets squarely out of the reach of the deposit insurer. The FDIC is now standing behind these margin claims, liquidating banks that have no assets left in them after repo counterparties bleed them dry of collateral and dealing with counterparty fallout among commercial banks with claims behind the repo collateral.

The confusion about Ms. Bair’s comments, therefore, is partially a cause of both a misunderstanding of the crisis and a desire to continue forward with the massive interruptions caused by BAPCA. Whether you look into the consumer bankruptcy effects described by Michelle White or the corporate bankruptcy effects described by Julia Whitehead, the inescapable conclusion is that BAPCA changed many moving parts of bankruptcy law broadly in favor of private creditors, the economic effects of which are still largely out of balance.

The FDIC has to deal with its own ramifications of BAPCA and the contracts the law incentivized. Just as the mortgages that contributed to the credit crisis were not your parents’ mortgages, the repos Bair discussed are not the traditional products you think of in repo markets. These repos were market funding products that resulted in the manifestation of “cliff risk,” where the entire financial market seemed to suddenly blow up in 2007 and 2008. Of course, had we known where to look we could have seen the pressures mounting, just as Ms. Whitehead describes in the experience with AHM, Bear, Lehman, and others. While those of us who have been inundated in investigations of the phenomenon – whether for legal case work, regulatory rulemaking, or academic research – now understand the dynamics, the popular reactions to Ms. Bair’s remarks shows that many market observers and policymakers are still in the dark. Worse yet, policymakers are relying on more margining as a fix for systemic risk from OTC derivatives, threatening more – not less – sudden failures like we saw at the peak of the panic.

Resolution authority would end TBTF concept, FDIC chief says

Source: Resolution authority would end ‘too-big-to-fail’ concept, FDIC chief says, April 27, 2009

"The administration’s proposed resolution authority for non-bank financial institutions would put an end to the outmoded concept of “too big to fail,” because it would provide a way for these institutions to fail without disrupting the entire financial system, said Sheila Bair, chairman of the Federal Deposit Insurance Corp.

Such a resolution system should be paid for by assessments on the financial firms subject to resolution, Bair said, as well as by losses recorded for their investors and creditors, and not be borne by the taxpayer, as in the current financial bailouts.

“Taxpayers should not be called on to foot the bill to support non-viable institutions because there is no orderly process for resolving them,” Bair said in a speech to the Economic Club of New York. “This is unacceptable, and simply reinforces the notion of ‘too big to fail’ ... a 25-year old idea that ought to be tossed into the dustbin.”

The FDIC was created to manage the orderly winding down of banks when banks were the main financial intermediaries, Bair recalled. But financial intermediation now takes place among a wide variety of non-bank institutions and laws have not kept pace with this evolution, making it virtually impossible to coordinate resolution of complex financial institutions, she said.

Normal bankruptcy procedures, designed to shield a company from creditors, cannot work with financial institutions because of their interconnectedness through credit transactions, Bair said.

“What's needed is a new way to unwind these big institutions,” she said. “We need an effective resolution mechanism, not a get-out-of-jail-free card.”

Paying for the new system by assessments on the firms would raise their cost of capital in the short term. Investors and creditors would come to understand their own responsibility for conducting due diligence, recognizing that these institutions could now fail.

“This is as it should be,” Bair said, recalling to the audience that she has been a lifelong Republican and an academic champion of free markets. “Everybody should have the freedom to fail in a market economy. Without that freedom, capitalism doesn't work.”

Bair repeated the argument she has made in testimony before Congress that the FDIC is the best-equipped agency to take responsibility for this new resolution authority, or to at least be part of the mechanism for winding down large financial institutions."

Federal Reserve Bank of Kansas City proposes a form of resolution authority

Federal Reserve Bank of Kansas City President Thomas M. Hoenig has been a strong proponent of addressing the issue of so-called "too-big-to-fail" financial firms by establishing a legal process that is consistent to firms of all sizes and holds those responsible for the firms condition accountable for its performance. The Federal Reserve Bank of Kansas City has prepared this document explaining exactly how that process could work.

Global approaches to "resolution"

EU bank resolution proposal

Basel Committee's Cross-border Bank Resolution Group

Executive Summary

The Cross-border Bank Resolution Group (CBRG) of the Basel Committee on Banking Supervision (Basel Committee) developed the following Recommendations as a product of its stocktaking of legal and policy frameworks for cross-border crises resolutions and its follow-up work to identify the lessons learned from the financial crisis which began in August 2007. The background and supporting analysis for the following Recommendations are explained in the balance of this Report.

Recommendation 1: Effective national resolution powers

National authorities 1 should have appropriate tools to deal with all types of financial institutions in difficulties so that an orderly resolution can be achieved that helps maintain financial stability, minimise systemic risk, protect consumers, limit moral hazard and promote market efficiency. Such frameworks should minimise the impact of a crisis or resolution on the financial system and promote the continuity of systemically important functions. Examples of tools that will improve national resolution frameworks are powers, applied where appropriate, to create bridge financial institutions, transfer assets, liabilities, and business operations to other institutions, and resolve claims.

Recommendation 2: Frameworks for a coordinated resolution of financial groups

Each jurisdiction should establish a national framework to coordinate the resolution of the legal entities of financial groups and financial conglomerates within its jurisdiction.

Recommendation 3: Convergence of national resolution measures

National authorities should seek convergence of national resolution tools and measures toward those identified in Recommendations 1 and 2 in order to facilitate the coordinated resolution of financial institutions active in multiple jurisdictions.

Recommendation 4: Cross-border effects of national resolution measures

To promote better coordination among national authorities in cross-border resolutions, national authorities should consider the development of procedures to facilitate the mutual recognition of crisis management and resolution proceedings and/or measures.

Recommendation 5: Reduction of complexity and interconnectedness of group structures and operations

Supervisors should work closely with relevant home and host resolution authorities in order to understand how group structures and their individual components would be resolved in a crisis. If national authorities believe that financial institutions’ group structures are too complex to permit orderly and cost-effective resolution, they should consider imposing regulatory incentives on those institutions, through capital or other prudential requirements, designed to encourage simplification of the structures in a manner that facilitates effective resolution.

Recommendation 6: Planning in advance for orderly resolution

The contingency plans of all systemically important cross-border financial institutions should address as a contingency a period of severe financial distress or financial instability and provide a plan, proportionate to the size and complexity of the institution, to preserve the firm as a going concern, promote the resiliency of key functions and facilitate the rapid resolution or wind-down should that prove necessary. Such resiliency and wind-down contingency planning should be a regular component of supervisory oversight and take into account cross-border dependencies, implications of legal separateness of entities for resolution and the possible exercise of intervention and resolution powers.

Recommendation 7: Cross-border cooperation and information sharing

Effective crisis management and resolution of cross-border financial institutions require a clear understanding by different national authorities of their respective responsibilities for regulation, supervision, liquidity provision, crisis management and resolution. Key home and host authorities should agree, consistent with national law and policy, on arrangements that ensure the timely production and sharing of the needed information, both for purposes of contingency planning during normal times and for crisis management and resolution during times of stress.

Recommendation 8: Strengthening risk mitigation mechanisms

Jurisdictions should promote the use of risk mitigation techniques that reduce systemic risk and enhance the resiliency of critical financial or market functions during a crisis or resolution of financial institutions. These risk mitigation techniques include enforceable netting agreements, collateralisation, and segregation of client positions. Additional risk reduction benefits can be achieved by encouraging greater standardisation of derivatives contracts, migration of standardised contracts onto regulated exchanges and the clearing and settlement of such contracts through regulated central counterparties, and greater transparency in reporting for OTC contracts through trade repositories. Such risk mitigation techniques should not hamper the effective implementation of resolution measures (cf. Recommendation 9).

Recommendation 9: Transfer of contractual relationships

National resolution authorities should have the legal authority to temporarily delay immediate operation of contractual termination clauses in order to complete a transfer of certain financial market contracts to another sound financial institution, a bridge financial institution or other public entity. Where a transfer is not available, authorities should ensure that contractual rights to terminate, net, and apply pledged collateral are preserved. Relevant laws should be amended, where necessary, to allow a short delay in the operation of such termination clauses in order to promote the continuity of market functions. Authorities should also encourage industry groups, such as ISDA, to explore development of standardised contract provisions that support such transfers as a way to reduce the risk of contagion in a crisis.

Recommendation 10: Exit strategies and market discipline

In order to restore market discipline and promote the efficient operation of financial markets, the national authorities should consider, and incorporate into their planning, clear options or principles for the exit from public intervention.

Cross-border Bank Resolution Group recommendations (Lehman)

4. Lehman Brothers

Regulation and Business Structure

49. The Lehman Brothers group consisted of 2,985 legal entities that operated in some 50 countries. Many of these entities were subject to host country national regulation as well as supervision by the Securities and Exchange Commission (SEC), through the Consolidated Supervised Entities (CSE) programme in the United States. Under this programme, the SEC monitored the ultimate holding company of the group, Lehman Brothers Holdings, Inc (LBHI). The CSE programme met the provisions of the EU’s Financial Conglomerates Directive and allowed the US investment banks to operate in Europe subject to SEC supervision. The CSE programme also included the requirement that LBHI maintain regulatory capital in accordance with a capital adequacy measure computed under the

Basel II Framework and addressed liquidity risk.

50. The Lehman structure was designed to optimise the economic return to the group whilst achieving compliance with legal, regulatory and tax requirements throughout the world and enabling the firm to manage risk effectively. It consisted of a complicated mix of both regulated and unregulated entities. The flexibility of the organisation was such that a trade performed in one company could be booked in another. The lines of business did not necessarily map to the legal entity lines of the companies. The group was organised so that some essential functions, including the management of liquidity, were centralised in LBHI. Structures of this complexity are common in large international financial institutions.

Resolution of a large cross-border financial institution - liquidity

51. An effective and orderly resolution of a large cross-border financial institution, while maintaining its key operations, requires a source of liquidity so that the firm can meet its ongoing trading and other commitments while it winds itself down or seeks an acquirer. This is demonstrated by the contrasting fates of the US broker-dealer (LBI), which did not immediately file for bankruptcy, and the London investment firm (LBIE). The Federal Reserve Bank of New York agreed to provide liquidity to LBI in order to effect an orderly wind-down outside of bankruptcy which ultimately resulted in the purchase of certain assets and assumption of certain liabilities by Barclays Capital. LBIE, however, relied on LBHI (the holding company) for liquidity, which ceased to be available when LBHI filed for bankruptcy. The ultimate outcome was that LBHI, the remainder of LBI not acquired by Barclays Capital, and LBIE are being wound down by insolvency officials who are experiencing a myriad of challenges. LBHI subsidiaries in jurisdictions such as Switzerland, Japan, Singapore, Hong Kong, Germany, Luxembourg, Australia, the Netherlands and Bermuda are also undergoing some type of insolvency wind-down proceedings in their respective jurisdictions. Coordination among these proceedings has been limited, at best.

Based on the Lehman experience, the following factors are particularly relevant to effective crisis resolution:

  •  If an acquirer for the entire firm can be found in an appropriate timescale, trading counterparties and other parties providing short-term funding will expect some sort of guarantee in the interim for them to continue to do business with the firm until the transaction closes – this can be challenging to achieve in a tight timeframe;
  •  As the amounts of liquidity needed are likely to be sizable, governmental resources may be required;
  •  For international firms and groups of this degree of complexity, a prepared, orderly resolution plan would be of great assistance to the authorities;
  •  Monitoring by regulators and the interplay of insolvency regimes are important;
  •  Group structures create interdependencies within the organisation that responsible regulators need to understand and monitor for both going concern and gone concern purposes;
  •  In the event of the failure of a cross-border financial institution, once the relevant component entities enter into insolvency proceedings the insolvency regimes applicable to the major entities are likely to be separate proceedings, serving different policies, with different priorities and objectives; and
  •  These differences continue to make coordination and cooperation among insolvency officials difficult as such coordination and cooperation may conflict with the duties of the officials to an entity’s creditors. To do their job effectively, insolvency officials may need access to information and records that are part of an insolvency proceeding in another jurisdiction.

Problems with returning client assets and monies

52. Even where the legal regime protects client assets and client monies held by a financial institution, the ability of those clients to quickly access their assets once insolvency proceedings begin is affected by a number of factors including:

  •  The institution’s record-keeping;
  •  Other claims the institution or its affiliates may have against the client;
  •  Sub-custody or other arrangements with affiliates that are also in insolvency proceedings; and
  •  The duties of insolvency officials to creditors generally.


53. For a large, complex financial institution there are multiple “home” and “host” regulators. Considering the speed at which a crisis can evolve it can be difficult for all interested authorities to communicate effectively and have access to information and actions taken in other jurisdictions which are relevant for their markets.

Cross border resolution issues

Source: Fail-safe The Economist, Aug 20th 2009

"THE failure on August 14th of Colonial BancGroup of Alabama, a lender with $25 billion in assets, was also an example of a continuing success story: America's resolution regime for deposit-taking banks. The Federal Deposit Insurance Corporation (FDIC) calmly seized the bank and sold its branches and deposits to BB&T, another bank. Borrowers continued to make their repayments. Contrast that with the slow-motion failure of Britain's Northern Rock early on in the crisis, where Parliament had to pass emergency laws to take the bank into public ownership.

It makes sense to have special insolvency procedures for banks. Traditional court-led resolutions used by ordinary companies proceed too slowly. Banks are subject to losses of confidence that can infect the entire financial system. Taking action only when a bank is insolvent is too late. The FDIC, for example, can step in if a bank's ratio of tangible equity to total assets drops below 2%. America has learned, however, that such considerations do not just apply to banks. When troubles emerged at Bear Stearns, Lehman Brothers and AIG last year, American authorities were hamstrung. Because none was technically a bank, the authorities could not intervene in the way they did with Colonial.

These flaws are being addressed. Bills sent to Congress late last month would allow the Treasury to appoint the FDIC or the Securities and Exchange Commission as receiver for any large "financial holding company" that posed a threat to financial stability, although regulators are squabbling over who would get to make the final decisions. For its part, Britain has had a new bank-resolution regime since February, one that the International Swaps and Derivatives Association considers "state of the art". Now, when the Financial Services Authority, a regulator, judges a bank (or insurer) of any size to be dangerously close to insolvency, the Bank of England can seize control, bring it into public ownership or sell parts of it to other banks.

Winding up the biggest financial firms will still be hideously tricky, however. Private buyers are less likely to be able to swallow them whole, for one thing. Counterparty networks are more complex. In both Britain and America regulators are asking firms to produce "death plans" that lay out how they can be efficiently liquidated or dismembered under financial stress. The American Treasury's experiences with Bear Stearns and AIG showed that these firms would be almost impossible for a government administrator to carve up in a crisis without an instruction manual.

Larger firms tend to be international ones, too. Companies like Citigroup or HSBC operate with intricate corporate structures across different jurisdictions, yet it is not clear how they would be resolved across borders. America has long operated a nationalistic insolvency regime that ring-fences the domestic assets of banks that become insolvent, whether they are American or foreign, in order to compensate American deposit-holders. More effort should have gone into clarifying international insolvency, say some. "Britain might introduce a new special resolution regime, but it won't work properly if that institution has branches in America," says Robert Bliss of Wake Forest University.

Larger financial firms also benefit from an implicit government guarantee that they will be bailed out if they get into trouble. In theory, resolution regimes could help instil greater market discipline by specifying ahead of time what would happen to shareholders and creditors in the event of a failure: mandatory haircuts, say, or compulsory debt-to-equity conversions. In practice, official proposals have not yet headed down this path. Having bailed out so much of the system this time round, promises not to do so again ring a touch hollow. And if they were seen as credible, pre-specified losses would hike the costs of bank financing.

As it is, creditors' rights have arguably been weakened by the new and proposed resolution regimes. Because tottering banks in America and Britain can be seized before they are even insolvent, some reckon that shareholders' property rights are at risk of being illegally infringed. Others worry that creditors of failing financial firms have no judicial recourse. "In ordinary bankruptcy proceedings, the creditors do not get to make the decisions about how to wind up the afflicted firm, so why should the government when it becomes a creditor?" asks Mr Bliss."

EU plans on bank resolution could hit bond investors

Investors holding uninsured bonds issued by banks in danger of failing may face haircuts or forced conversions to equity if European Commission proposals on bank resolution go ahead.

Hervé Goulletquer, head of fixed income markets research at Crédit Agricole Corporate and Investment Bank, says the plans would have a detrimental effect on investor appetite for bonds from financial institutions. “You have to consider long-term confidence, not just in terms of concerns investors may have about future events, but also because of the confusion created by making changes to seniority of payments,” he says.

European finance ministers met in Madrid on April 17 to discuss ways to prevent the further use of public funds in any future banking crisis. The suggestion of imposing haircuts or conversions as a way of providing funds to distressed firms was put forward by Michel Barnier, European commissioner for internal market and services.

In a letter to Elena Salgado, Spain’s minister of economy and financial affairs, Barnier said banks’ crisis strategies should be based on the “polluter-pays principle”, rather than relying on government bailouts. He wrote: “Citizens and taxpayers will not accept a repetition of the events of 2008 and 2009, and in particular the use of public funds to bail out banks.”

Instead, he added: “Shareholders, uninsured creditors (through haircuts) and management should pay first.”

In a working paper setting out proposals for a crisis management framework in the European Union, the Commission said: “Pre-insolvent recapitalisation through such mechanisms could allow the firm to remain as a going concern, either indefinitely, or for at least as long as is necessary for authorities to deal effectively with complex business activities, for example to unwind its derivatives book.”

The Commission intends to publish further communications on resolution funds and crisis management in June and the autumn of this year, before setting out legislative proposals next spring.

If the proposals are approved, investors would need to price in the risk of a likelihood of a haircut or equity conversion when purchasing bonds.

Karl Clowry, a finance and restructuring partner at law firm Paul Hastings, says this would incentivise financial institutions with basic capital structures to be more transparent to convince investors there are no hidden risks in, for instance, their derivatives or treasury activities.

“This should allow the banks to gain cheaper credit,” says Clowry. “But [for more complex institutions], when you have an investment bank allied to a deposit-taking institution, then obviously it is less transparent, and people may feel they have to be a little more aggressive with their pricing of the likelihood of a haircut or conversion.”

Although private and corporate depositors would remain protected from absorbing losses, the order of creditors’ priorities would be altered under the Commission’s plans. “Depositors would be given a super-priority in the event of the insolvency of a bank, over and above the unsecured bondholders, who would normally be ranked equal. That would represent a big change,” says Clowry.

Robin Creswell, managing principal of investment management firm Payden & Rygel, likens the possibility of haircuts and conversions to a moratorium on bond coupon payments. This is a course of action the European Commission took last November, restricting the UK’s Lloyds Banking Group and Belgian bank KBC from making payments on tier 1 and tier 2 instruments for two years.

“It is attacking the last line of the capital structure, and that is extremely damaging,” says Creswell, adding that pension funds could be the first to suffer under such proposals as they are substantial holders of bank debt.

Creswell is also concerned that plans to impose losses on bond investors could be adopted in non-financial sectors. “If you can apply a haircut in the financial sector, where do you draw the line?

The way people will resolve it is to say, ‘which corporations benefited from macro-prudential quantitative easing and macro protection from governments?’ But it is difficult to arrive at a non-arbitrary solution,” says Creswell.

IMF Executive Board assesses cross-border bank resolution

Yesterday, the Executive Board of the International Monetary Fund (IMF) released its assessment of a proposed framework for an enhanced system of resolution for the international class of systemically critical or “‘too complex to fail” institutions. The framework was developed by IMF staff members in a paper responding to G20 leaders, who, at their Pittsburgh summit in September 2009, called for input by the close of 2010 on how to “address cross-border resolutions” of important financial institutions.

IMF Directors first noted that sovereign interests often create conflicts between state regimes and have given rise to difficulties in coordinating resolution actions. Where laws do not prevent cross-border collaboration, national regulators often decline multinational approaches in favor of protecting the interests of their own stakeholders in times of crisis.

Directors considered a formal approach that would call for a treaty to create a regulatory body capable of enforcing rules in a cross-border resolution. Directors also acknowledged that the “de-globalization” or consolidation of critical institutions could substitute for a cross-border system by allowing large firms to align more precisely with the resolution regimes they operate in. Both approaches were ultimately rejected on related concerns over the potential deterioration of sovereignty under a formal regulatory hegemony and the impairment of market and capital access under a more localized trade system.

By contrast, Directors were generally receptive to the more “pragmatic framework” for enhanced coordination” outlined in the staff discussion paper. Central to the system would be a non-binding recognition of elements that would be implemented by national authorities:

  • Amending national laws to require authorities to coordinate resolution efforts with their counterparts in other countries to the fullest extent possible while protecting the interests of domestic stakeholders. National authorities would retain the ability to act independently as deemed necessary in good faith.
  • Restructuring national resolution regimes to ensure the maintenance of core coordination standards. This would entail the harmonization of policies on key issues such as non-discrimination against foreign creditors and the establishment of rigorous oversight mechanisms consistent with the Basel Committee on Banking Supervision’s Concordat on supervision. Nations would also create the capacity to implement an international solution.
  • Establishing criteria for ex-ante burden-sharing agreements with an emphasis on minimizing the need for public funding.
  • Creating procedural protocols for the coordination of cross-border resolution actions, including both information-sharing standards and rules to determine which forum would assume authority in resolving a particular international firm.

Directors agreed that countries with similar resolution regimes should act quickly to coordinate programs before expanding cooperative efforts, particularly where nations heavily rely on common institutions. Some Directors felt that the IMF should assume leadership in the process of assessing and developing joint resolutions systems.

Directors somewhat qualified their endorsement of the framework, emphasizing that several conceptual and technical issues required further consideration. They directed the staff to continue developmental discussions with their counterparts at the Financial Stability Board to capitalize on the experience and resources of both groups.

IMF - Special resolution regimes for financial institutions

III. Principles and Design of the Framework

A. Principles

These considerations imply that resolution regimes are needed to expand the set of tools available to the authorities in crisis prevention and management. The ultimate goal of the special resolution regime is to safeguard financial stability. Specifically, introduction of such regimes is desirable to:

  • (i) reduce the systemic impact of a potential failure;
  • (ii) afford control to the authorities;
  • (iii) shift the financial burden away from the taxpayer;
  • (iv) let losses be borne by existing shareholders; and
  • (v) reduce moral hazard and increase market discipline.

Reflecting these objectives, a consensus has begun to emerge as to the principal features that a resolution framework should comprise. In particular, sound practice is for the framework to

  • Allow the authorities to take control of the financial institution at an early stage of its

financial difficulties, through “official administration”

  • Empower the authorities to use a wide range of tools to deal with a failing financial

institution, without the consent of shareholders or creditors

  • Establish an effective and specialized framework for liquidation of the institution that assigns a central role to the authorities
  • Ensure clarity as to the objectives of the regime and define clearly the scope of judicial review
  • Promote information sharing and coordination among all authorities involved in supervision and resolution

The resolution regime is a key, but not the only, part of the broader financial stability framework. Prudential supervision has particularly close links to the resolution regime: an effective resolution regime helps to make supervision more effective, and effective supervision helps to identify and prevent problems in financial institutions even before a resolution is needed.

A strong resolution regime needs also to be complemented by robust deposit insurance mechanisms.

These should provide for adequate coverage, a high degree of ex ante funding, to raise confidence in the ability of the scheme to honor insured claims, and a rapid payout of insured deposits. These elements can reduce systemic risk arising from the closure of an institution, by reducing the incentives of depositors to “run”, and thus help make liquidation a credible threat, especially for smaller institutions. 6

B. Scope of Regime

Introduction of special resolution regimes requires careful reflection of the appropriate scope of the regime. For example, the regime currently operated in the United States applies only to commercial banks, and does not include bank holding companies and other financial institutions, which do not take deposits, but may still warrant inclusion in a regime that aims to reduce the impact of failure of systemically important institutions and financial groups. 7

The U.S experience has shown up investment banks—such as Bear Stearns and Lehman—as important examples of institutions that may need to be caught by a special resolution regime even if these institutions are not taking any retail deposits. The case of Bear Stearns in particular has highlighted that wholesale funding sources can be as liable to a “run” as retail deposits.

This means that swift intervention is required if liquidity pressures are not to jeopardize the solvency of the institution and cause repercussions in financial markets. The case of AIG highlighted that a financial institution can become a critical hub in the network of financial exposures. This type of institution may need to be caught by a resolution regime—as well as appropriate regulation—because the systemic impact of insolvency can be large. More generally, the U.S. experience has shown that it is not sufficient for resolution regimes to apply only at the level of a commercial bank subsidiary when the whole financial group is integrated, e.g. as regards its management of liquidity, and doubtful assets are held both inside and outside the banking subsidiary.

Recent proposals by the U.S. administration are designed to address these issues, by creating the status of a Tier 1 holding company, that would be subject to a special resolution regime at the group level and irrespective of whether it contained entities that took deposits.8

In Europe, the prevalence of the universal banking model means that most large and complex institutions will also take deposits. However, even here, Northern Rock and HRE were examples of institutions that relied on wholesale funding to a significant extent. It may be desirable for the scope of a special resolution regime to be robust to a potential trend away from business models that involve funding through retail deposits. That said, it is clear that— at a minimum—all deposit-taking institutions (banks) need to be within the scope of the regime.

For financial conglomerates, it may, more generally, be desirable for a special resolution regime to apply at the level of the parent company, rather than only at the level of each individual institution. This helps avoid the situation that financially integrated businesses are broken up in resolution; or alternatively that the cost of breaking up the integrated business is gauged too large and that fiscal support for the parent company is deemed the only possible alternative. 9

One way to approach the issue of defining the scope of the regime is for the law to enumerate the types of institutions, other than banks, that are to fall within its scope; or for the law to set out detailed criteria and quantitative thresholds that determine unequivocally whether any particular institution or financial group falls within scope. An alternative approach is for the law to set out the scope in more operational terms. This can be achieved by giving the resolution authority the power to “designate” particular non-bank institutions to fall under the scope of the regime.10

Such a designation could be made on the basis of a rigorous, but more qualitative assessment of the systemic risk posed by a given individual institutions against a suitable set of criteria. When such an assessment is conducted periodically and across all potentially relevant institutions, this permits a more dynamic framework, able to respond flexibly to developments in financial markets and changes to the business models of any particular institution.11

HM Treasury's "Special resolution regime"

  • 1.1 The Banking Act 2009 (the Act), covering England, Scotland, Northern Ireland and Wales, strengthens the UK's statutory framework for financial stability and depositor protection.
  • 1.2 The Act puts in place a permanent special resolution regime (SRR), providing the Financial Services Authority (FSA), Bank of England and the Her Majesty’s Treasury (the Authorities) with tools to protect financial stability by effectively resolving banks and building societies that are failing, while protecting depositors, taxpayers and the wider economy.
  • 1.3 This Code of Practice, issued in accordance with sections 5 and 6 of the Act, supports the legal framework of the SRR, and provides guidance as to how and in what circumstances the Authorities will use the special resolution tools. In particular, it sets out guidance on the use of:
    • the three stabilisation options: transfer to a private sector purchaser, transfer to a bridge bank and transfer to temporary public sector ownership;
    • the bank insolvency procedure, which facilitates the Financial Services Compensation Scheme (FSCS) in providing prompt payout to depositors; and
    • the bank administration procedure, for use where there has been a partial transfer of business from a failing institution.
  • 1.4 The Treasury has issued this Code having consulted the FSA, the Bank of England and the FSCS in accordance with section 6 of the Act. The Code is laid before Parliament on 23 February 2009.

FSA's Turner says break up banks only when they collapse

"Britain’s financial regulator said the country’s largest banks should only be broken up in the event of a collapse, stopping short of adopting suggestions by Bank of England Governor Mervyn King.

Banks would have to split their deposit-taking arms from securities units under so-called living wills that would take effect in the event of a failure, the Financial Services Authority proposed in a report today by Chairman Adair Turner. Lenders may also have to hold more capital against trading books and some derivatives would be cleared through central counterparties, the FSA said.

“The FSA has come in for some criticism for failing to prevent the crisis, so the message is you can’t carry on as you were,” said Rachel Kent, a regulatory lawyer at Lovells LLP in London. “The FSA are taking the helpful current political environment to do some regulatory housekeeping.”

Lawmakers and regulators worldwide differ on the best way to supervise banks that are so large their collapse could threaten the stability of the financial system. King this week repeated his backing for a plan to separate banks’ deposit- taking operations from securities units. Turner, 54, and the U.K. Treasury have said that enforcing such a split would be difficult and impractical.

“The fundamental problem we’re dealing with is volatility in credit extension,” Turner, 54, said at a press conference today. “By splitting out narrow banks and deregulating the rest, I think you make that position worse.”

Chancellor of the Exchequer Alistair Darling is writing laws to make banks write a living will that will enable a quick wind-down of institutions that fail. Some U.K. banks will have begun to produce wills by the end of 2009, the report said...

... Living wills will include how banks would sell units to other financial institutions and how they would reduce risky assets if they got into difficulty, the report said. Banks that that pose a systemic risk, either because of their size or their interconnectedness with other financial institutions, will need to produce wills, the report said.

The FSA said a capital or liquidity surcharge may be imposed on global banks to avoid one country being responsible for their rescue. The regulator said all lenders will need to hold more capital and banks currently making profits should consider retaining those earnings to boost capital reserves...

...March proposals by Turner for banks to hold more capital and liquid assets were largely adopted by the U.K. government and the Group of 20 Nations. Turner heads a committee at the Financial Stability Board, a group of central bankers, finance ministers and regulators that guides G-20 policy.

FSA wants "living wills"

"The global regulatory drive to force the biggest banks to pre-plan for their own demise will compel them to simplify their legal structures, potentially pushing up their tax bills, according to the head of the chief UK financial regulator.

In an interview with the Financial Times, Lord Turner backed international moves to force the big, systemically important banks to draw up “living wills”, wind-down plans in the event they fail.

But the chairman of the Financial Services Authority said this drive would also have the benefit of unravelling banks’ structural complexity used to minimise tax.

“Living wills will be a forcing device for the clarification and simplification of legal structures,” he said.

“In the past, authorities around the world have tended to be tolerant of the proliferation of complex legal structures designed to maximise regulatory and tax arbitrage. Now we may have to demand clarity of legal structure.”

He admitted that the reforms would be highly contentious.

Lawyers predicted that banks would resist fiercely any wholesale restructuring that could cost them hundreds of millions of dollars. They also warned that any such moves would be extremely hard to implement.

Louise Higginbottom, head of tax at Norton Rose, the law firm, said: “Many banks operate through a complex series of subsidiaries and branches. It’s taken years for these structures to evolve and killing them off at a stroke would be difficult.”

Leaders of the Group of 20 leading industrial economies are to meet in Pittsburgh this month with the aim of redesigning the world’s financial regulatory regime.

Meanwhile, in the US, Tim Geithner, Treasury secretary, on Wednesday said the G20 meeting in London on Friday would consider how countries should prepare an ”exit strategy” from their extraordinary fiscal and monetary stimulus schemes.

Scarred by the failure of Lehman Brothers a year ago, policymakers in both the US and the European Union have been pressing for a regime that would allow for the orderly wind-down of global financial institutions.

US officials appear to be most concerned about setting up a regime that would clarify the rights of different classes of creditors, while Europeans want to ensure that cross border claims are resolved fairly.

Lord Turner, who sits on the Financial Stability Board, which in turn sets the framework for the global rule-setters on the Basel Committee on Banking Supervision, defended the speed of the regulatory response to the banking crisis.

UK FSA "Approved persons" regime

"As the Director whose responsibilities include our Approved Persons regime, I am writing to clarify our new approach to approving and supervising persons performing significant influence functions (SIFs).

Our regulatory philosophy and more intrusive approach continue to place a great deal of emphasis on governance and consequently, the responsibilities of senior management of firms. In view of the shortcomings exposed by the financial crisis in the governance and risk management of some regulated firms, we made changes last year to how we approve and supervise persons performing SIFs, in particular we:

  • introduced procedures to interview, at our discretion, candidates applying to perform certain SIF roles in particular firms; and
  • placed greater emphasis on monitoring the performance of persons already performing SIF roles. This includes reviewing more critically the competence of persons performing SIFs as part of ARROW assessments.

Our expectations of persons performing SIFs are set out clearly in our rules and are well summarised by our Statements of Principle for Approved Persons (APER) contained in our Handbook. Our assessment of the competence of persons performing SIFs will be based on these expectations. We have also said previously that one of the key questions we expect relevant senior management of a firm to be able to answer is: What are the circumstances under which the firm will fail? In assessing competence, we will expect senior management to be able to demonstrate their understanding of the inherent risks in the business/markets and to articulate what plans are in place to mitigate the risk of failure..."

Australian insolvency reform

The Hon Chris Pearce, Parliamentary Secretary to the Treasurer, has released details of a package of reforms to improve the operation of Australia’s insolvency laws.

Ireland nationalizes banking system

By Christmas, the Government will be controlling -- at a safe distance -- about €295bn of bank assets, seven times the amount of assets managed by NAMA.

It was a long time ago, but in September 2008, Finance Minister Brian Lenihan was steadfastly opposed to nationalisation as a policy, but horrifying events and the poor quality of Irish banks' loan books have propelled him toward a solution he would have preferred to avoid.

Of course, nationalisation is an elastic word and technically AIB will only be 90pc-owned by the Government by year end. It will maintain a stock market listing and a small rump of non-government shareholders.

Likewise for Irish Nationwide and EBS, they are technically controlled through special investment shares, but ultimately they are nationalised in all but name (EBS could yet be bought by the private sector). Anglo, on the other hand, is a wholly owned subsidiary of the Department of Finance.

If one adds their assets together, it means the Government has nationalised the majority of the banking sector, with only Irish Life & Permanent remaining entirely independent. Bank of Ireland is semi-independent, but the Government does hold a highly influential 36pc stake through the national pension fund.

This week's events copper-fasten government control over the banking sector, with the minister admitting for the first time that AIB will have to come under the State's umbrella for the foreseeable future.

EC Approves Danish Bank Resolution Scheme

On Thursday, the European Commission approved, under EU State Aid rules, a scheme for the resolution of distressed Danish banks. the scheme "provides for an orderly winding up of the failing bank, transferring its assets and part of its liabilities to a bridge bank to be set up under the aegis of the Danish Financial Stability Company. The latter would provide capital, and, if necessary, liquidity to the bridge bank." The EC concluded that the Danish resolution scheme was consistent with the EC's Guidance Communication on state aid to address the financial crisis, noting that it "is limited to the minimum necessary to ensure an orderly winding-up," "burden-sharing is ensured by excluding shareholders and subordinated debt holders of the failed bank from any benefit from the aid," and "strong limitations on the activities and the lifespan of the bridge bank [that] will minimise distortions of competition."

Legal scholars writings

Columbia Law and Economics Working Paper No. 362

Abstract: Lehman’s bankruptcy has triggered calls for new approaches to rescuing systemically important institutions. This essay assesses and confirms the need for a new approach. It identifies the inadequacies of the Bankruptcy Code and advocates an approach modeled on the current regime governing commercial banks. That regime includes both close monitoring when a bank is healthy and aggressive intervention when it is distressed. The two tasks - monitoring and intervention - are closely tied, ensuring that intervention occurs only when there is a well-established need for it. The same approach should be applied to all systemically important institutions. President Obama and the Congress are now considering such an approach, though it is unclear whether it will establish a sufficiently close connection between the power to intervene and the duty to monitor. The proposed legislation is unwise if it gives the government power to seize an institution regardless of whether it was previously subject to monitoring and other regulations.

"The current issue of Institutional Risk Analytics discusses an issue that is a tad arcane for many readers, but more important than it seems on the surface. The 2005 bankruptcy law changes, among other things, provided that that derivative transactions were exempt from bankruptcy provisions, meaning that creditors have to put in their claims against the failed business and have the court sort out who gets what. The Financial Times explained how this provision had the perverse effect of accelerating the collapse of Bear, Lehman, and AIG:

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.

The new rules were intended to insulate financial companies from the collapse of a large counterparty, such as a hedge fund, by making it easier for them to unwind trades and retrieve collateral.

However, experts say the new rules might have accelerated the demise of Bear, Lehman and AIG by removing legal obstacles for banks and hedge funds that wanted to close positions and demand extra collateral from the three companies…

The changes in the code expanded the scope and definition of financial transactions not covered by bankruptcy rules to include credit default swaps and mortgage repurchase agreements – products used widely by Lehman, Bear and AIG.

Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag.

Institutional Risk Analytics adds some new wrinkles today: first, that it was predictable that these rules would be challenged on constitutional grounds, and second, the high odds of successful challenge makes the Fed’s argument that it had to bail out AIG for 100% of the value of its credit default contracts dubious. As an aside, Andrew Ross Sorkin’s account makes it abundantly clear that while the top bankruptcy lawyer in the US, Harvey Miller, had been retained by Lehman but was kept idle until the authorities had decided Lehman had to file for bankruptcy, no one in authority bothered to talk to him to understand the implications and process of a bankruptcy. There is no evidence that the Fed or Treasury sought advice on bankruptcy mechanics and issues from their own outside counsel.

Note the argument that Whalen makes, that the banks were keen to have this rule in place. Is the Fed’s implicit alignment with this position (ie, not considering challenging it, or arguing with the banks that were demanding more collateral that the Fed, which as of October 2008, was a creditor to AIG, could and would challenge this position in court? This is a significant source of potential leverage the Fed had: “Let’s pay this out. You don’t accept our offer of 85 cents on the dollar. You put AIG into involuntary bankruptcy. Aside from the fact that you become public enemy number one by destroying the the markets and probably your own firms in the process, we WILL challenge the BK laws as far as the seniority of your derivatives contracts are concerned. Do you really want us coming after you for the collateral you already received, arguing it is now fraudulent conveyance? I don’t think so.” There is such a thing as bluffing and jawboning, and the Fed made no efforts along those lines. As IRA put it:

We have always held the view that the attempts by the large dealer banks, ISDA and regulators to carve out a special, privileged place in the law for OTC derivatives contracts in the event of default is inherently unfair and is doomed to failure, or at least would be challenged, on Constitutional grounds. This case and others make that challenge and review process a reality and also leaves much of the world of complex structured finance in a shambles when it comes to the legal reality of counterparty risk.

Indeed, the same legal art that gave the swap counterparties in this latest case the impression that they were senior to the other creditors of the bankruptcy estate was used by former Treasury Secretary Hank Paulson and his successor, Timothy Geithner, to justify the rescue of American International Group (AIG). The very same type of investment contracts that Secretary Paulson and Secretary Geithner swore under oath, over and over again, just had to be paid at par in the case if AIG were just set aside by New York Bankruptcy Judge James Peck.

And notice that the world has not ended when the holders of OTC contracts are treated like everyone else. Indeed, Judge Peck has made a number of rulings over the past two years re-leveling the playing field between holders of OTC contracts and other claims against the Lehman bankruptcy estate. As we have noted before, the admirable conduct of the Lehman Brothers bankruptcy case by Judge Peck and US Bankruptcy Trustee Harvey Miller is the starkest condemnation possible of the AIG bailout, a hideous political contrivance that ranks with the great acts of political corruption and thievery in the history of the United States.

And IRA notes in this very useful post that the implications extend well beyond Lehman and AIG:

The question of the enforceability of the documentation in a complex structured securitization involving OTC swaps is not just a matter of debate in the AIG case. Across the US and around the world, investors and trustees are grappling with this same issue. The result is litigation by bond trustees against bond issuers as well as claims by guarantors such as MBIA (MBI) and the housing GSEs, including the Federal Home Loan Banks, against sponsor banks. Many of these claims regarding derivatives are being made in the context of claims for the repurchase of defaulted residential and commercial loans.

The wave of loan repurchase demands on securitization sponsors is the next area of fun in the zombie dance party, namely the part where different zombies start to eat one another. The GSE’s are going to tear 50-100bp easy out of the flesh of the banking industry in the form of loan returns on trillions of dollars in exposure, this as charge-offs on the several trillion in residential exposure covered by the GSEs heads north of 5%. The damage here is in the hundreds of billions and lands in particular on the larger zombie banks, especially Bank of America (BAC) and Wells Fargo (WFC).

So now that the losses on dud mortgages are continuing to rise, investors and guarantors are seeking recourse from the banks that originated the paper. And it looks like they will have some success. This is going to get interesting and downright ugly.

IRA highlights one case, where claims against Countrywide are being asserted not just against the subsidiary, but against BofA itself. Our impression was that BofA was confident that it could limit its liability to the assets held by BofA (that it, unhappy investors would not be able to make claims that would impair BofA ex Countrywide; if not, you’d be nuts to do the dea:

Notice, for instance, that in the MBI litigation against Countrywide Financial et al, MBIA Insurance Corporation v. Countrywide Home Loans, Inc. et al. the lawsuit now includes BAC explicitly.

The action “arises out of the alleged fraudulent acts and breaches of contract of Countrywide in connection with fifteen securitizations of pools of residential second-lien mortgages” Take particular care to savor the fact that these are second lien pools and that, where defaults have occurred on the primary mortgage, loss severities on the seconds will tend to be 100%. Or the cost could be more than par if you count the cost of remediation and recovery efforts.

Note the fact that MBIA is trying to go after BofA itself does not mean it will succeed. But expect to see more of this sort of action.

It is interesting that people keep trying to reinvent the wheel in this financial crisis. Early policies tried to reinvent lender-of-last resort capabilities, TARP was (half) an attempt at recapitalization policy, and other policy choices sought to avoid those nasty good bank/bad bank strategies that force banks to reveal their holdings, but which have also effectively ended banking crises in the last hundred years in countries throughout the world.

What is interesting most recently is how policymakers are attempting to once again reinvent bank resolution policy to address too-big-to-fail and, most interestingly, how they are quite willing to take significant departures from free market capitalism rather than seek simple solutions to the immediate problem at hand.

Recently proposed “systemic” resolution policy seeks to provide a money-pot for large “systemically important” institutions to keep them from ever failing it the first place. Of course, such policy just means that we tie the US fiscal failure to the institutional failure, but that seems to be the accepted approach.

There is a much better and simpler approach that has yet to be entertained. Adopting such an approach, however, requires policymakers to take into account both banking industry structure and private sector bankruptcy law.

Consider for a moment the following: the important regulatory issues to be worked out are not commercial bank issues, per se, but bank holding company (BHC) issues left over from Gramm-Leach-Bliley (GLB).

A commercial bank is the entity chartered by an authority such as the Office of the Comptroller of the Currency (OCC) (for national banks) or state banking authorities (for state banks). The Office of Thrift Supervision charters Federal Savings Banks and Thrifts. State authorities charter similar institutions. The important matter is that none of those entities can legally undertake proprietary trading or any of the other nasty activities that are thought to engender surprising systemic linkages. In fact, all of them are functionally regulated by examination staff who tell them what products they can invest in and place strict functional limits on their activities. If the institutions fail to meet those functional and investment limits, the authority has the right to remove the institution’s charter, without which the institution cannot operate legally. Hence, the chartering authority has the legal ability to close the institution.

Bank holding companies were first allowed in 1956. Sometimes a BHC would apply for authority to own subsidiaries that were not banks, such as investment banking subsidiaries. The idea was (and is) that those would be separated from the commercial bank subsidiary by various constraints between the two. While some countries do allow “universal” banking, wherein those functions can be carried out inside the legally chartered bank, the US does not do so, limiting the functions to legally separate subsidiaries within the holding company. The chartering authority is the primary regulator of the bank; the SEC is the regulatory authority for investment banking subsidiaries; other regulators regulate things like insurance and other subsidiaries within the holding company. The Federal Reserve regulates the BHC.

The Federal Reserve, as regulator of BHCs, has never had the authority to remove a holding company charter in the manner that a bank charter is removed from a chartered commercial bank. Until recently, such authority did not matter. When bank holding companies were first allowed in 1956, they were largely comprised of legally chartered banks. Hence, when a number of those banks failed (as in MCorp in 1989), the BHC naturally failed, as well.

GLB enacted a new type of bank holding company – a financial services holding company – wherein chartered and regulated commercial banks were expected to be a minority among the institutional subsidiaries that make up the firm. Hence, we had a problem wherein the commercial bank could be failing, but the holding company may not be bankrupt. To seize the commercial bank may or may not debilitate the holding company. Moreover, without examination authority over non-bank subsidiaries and rights to control the resolution, substantial unintended consequences for the other subsidiaries may result (i.e., the closing authority could be successfully sued).

To me, the important issues in those arrangements that need to be reconciled through regulatory reform, therefore, are how to maintain information on the holding company structure and interrelationships and get authority to close the BHC.

Information is easy enough. Remember, we are only talking about reports here, not functional regulation. Moreover, much of the information you would want is already available. Remember, CDS counterparty information was already available via DTCC prior to the AIG bailout – the regulators just hadn’t thought to ask. The necessary reform, therefore, is primarily internal to the chartering authorities: to make the review of such “outside” information mandatory for commercial bank and BHC supervision.

But BHC supervisors still need authority to close the institution if they see improprieties. Remember, chartering authorities only have the right to close the commercial bank. Once the commercial bank is closed, the FDIC acts as a dedicated trustee that handles commercial bank bankruptcy cases.

It is not clear that the FDIC currently could not resolve the non-bank portions of the BHC, as well, without additional legislation. The FDIC technically steps aside once it has sold enough assets to cover its deposit outlays. In practice, it often resolves the rest of the firm for the responsible authority.

Opponents of this approach have asked, “where will the money to fund the non-bank portions of the BHC during the resolution come from?” Well, the only reason we carry assets on the Federal Government’s books for commercial bank resolutions is to cover the costs of depositor advances. In fact, if not for the presence of depositors, there would be little reason to separate commercial banks from other firms in the bankruptcy code. For private-firm restructurings, debtor-in-possession (DIP) loans usually suffice – and if they do not, the firm has little going concern value anyway.

While an argument can be made that the FDIC also manages asset market overhang, that function is provided for creditors of non-bank firms in the requirement that the private trustee maximize creditor value in the liquidation.

The question, therefore, is why do we need a whole new section of bankruptcy code for non-bank portions of BHCs? It seems to me that we are unnecessarily reinventing the wheel, trying to fix one of the best-functioning bankruptcy systems in the world. Let’s just fix GLB to give the BHC supervisory authority both the responsibility and the authority to act appropriately.

In closing, I reiterate: most of the problems for regulatory reform (aside from housing policy) are bank holding company problems. Most of them are not hard to fix. But fixing them requires institutional knowledge that does not seem to be possessed by most policymakers, even those in charge of regulatory agencies. As a result, the struggles to “hoist another policy proposal up the flagpole and see how it flies” are creating unnecessary policy volatility that is hampering bank funding and economic growth. We need to take a far more thoughtful, straightforward, and meaningful approach to regulatory reform.


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