Title II of Dodd-Frank creates a new resolution authority, called the Orderly Liquidation Authority (OLA), for systemically important financial institutions — which, crucially, includes financial holding companies (all the major US banks are organized as FHCs now). The OLA is patterned on the Federal Deposit Insurance Act, which lays out the FDIC resolution authority for commercial banks. The OLA, like the FDIC resolution authority, gives the FDIC a range of tools to liquidate a large nonbank financial institution while also mitigating systemic risk. No one is arguing that commercial banks that are seized and resolved by the FDIC are being “bailed out,” because they’re not — that’s why we call them “failed banks.” The FDIC resolution authority is just an alternative insolvency regime; but, obviously, it’s still an insolvency regime. So presumably, the people who say that “Dodd-Frank did nothing to end TBTF!” are arguing that a large FHC would not be resolved through the OLA.
The real question, then, is:
If a large financial holding company were on the brink of failing, would regulators resolve the FHC through the OLA?I think it’s almost certain that regulators would, in fact, resolve a large FHC through the OLA, because it would work.
As I noted in my previous post, one of the main reasons that Lehman’s failure was such a catastrophic event for the markets was Lehman’s complete and total lack of preparation for a bankruptcy filing. Any serious analysis of Dodd-Frank’s resolution authority therefore has to recognize that Dodd-Frank also requires any financial institution subject to the new resolution authority to regularly submit a “resolution plan” (a.k.a. “living will,” or “funeral plan”) to regulators. I’ve slowly become a big fan of the resolution plan. I was never against it, and it still won’t do what its original proponents intended it to do, but it will perform an absolutely vital function: ensuring that the banks keep all the information/data necessary to execute an orderly resolution readily available. Significantly, § 165(d) of Dodd-Frank requires that resolution plans include:
(B) full descriptions of the ownership structure, assets, liabilities, and contractual obligations of the company;This is hugely important. The absence of this information made everything about Lehman’s bankruptcy significantly worse, as I discussed previously. In addition to the information in (B) and (C) above, the Fed and FDIC should require that the resolution plan describe the terms and conditions that a potential acquirer of the bank’s primary entities would have to be prepared to agree to (i.e., if you buy X, you’d also be legally obligated to assume the obligations of Y). They should also require the resolution plan to include a comprehensive index of customer accounts, and important documents such as clearing agreements and Global Master Repurchase Agreements with major counterparties. All of this is eminently doable, I promise you, and it’s something the banks should have on hand anyway, just as a matter of good business practices. (I know for a fact that at least some banks would be able to pull most of this information together in a single weekend.)
(C) identification of the cross-guarantees tied to different securities, identification of major counterparties, and a process for determining to whom the collateral of the company is pledged; and
(D) any other information that the Board of Governors and the Corporation jointly require by rule or order.
The process prescribed by Dodd-Frank for submitting resolution plans also gives the FDIC an opportunity to identify legal structures and processes that would cause serious problems in a resolution (like, for instance, Lehman’s now-infamous “RASCALS” process). Not only that, but the statute actually gives the Fed and FDIC the authority to do something about problem issues preemptively, which is huge.
In short, the presence of a resolution plan will make the decision to resolve a large FHC under the OLA significantly less daunting.
Now we get to the actual resolution. What would the resolution of a large financial holding company look like under the OLA? First, the FDIC would be appointed as receiver of the holding company, all its US primary entities (except for any insurance companies, which are still resolved by the states), and all its US booking entities. Technically, the FDIC would be appointed as receiver of the US commercial bank under the Federal Deposit Insurance Act rather than the OLA, but this is a distinction without a difference for our purposes, as the statutes are substantially similar. As receiver, the FDIC would succeed to all the rights, titles, powers, and privileges of these companies and their assets — in other words, the FDIC would be in complete control.
The FDIC resolves the vast majority of failed commercial banks through what’s known as “purchase and assumption” agreements (called “P&As”), in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. For example, the FDIC resolved WaMu — which had over $300bn in assets — through a P&A with JPMorgan, in which JPM acquired all of the assets ($296bn), and almost all of the liabilities ($265bn) of WaMu’s depository instutition. Crucially, JPM left behind some $28bn of WaMu’s senior unsecured debt, subordinated debt, and preferred stock — and those creditors took huge haircuts. The particular structure of the P&A, and of the resolution, depends on the situation the FDIC is facing.
In the case of a large financial holding company, there are essentially four types of situations that the OLA needs to be able to handle:
(1) A buyer for the entire FHC can be identified prior to triggering the OLA;Let’s take these situations in turn.
(2) A buyer for only some of the FHC’s assets can be identified prior to triggering the OLA (most likely);
(3) Potential buyers have been identified, but no agreement has been reached by the time the OLA is triggered;
(4) No buyer can be or will ever be identified (least likely).
(1) A buyer for the entire FHC can be identified prior to triggering the OLA
This is an easy one. Dodd-Frank gives the FDIC broad authority to arrange for the sale of entities in receivership, or for selected assets of the entities. The FDIC would just do a straight P&A for all the assets and liabilities of the FHC and its subsidiaries in receivership. Done and done.
(2) A buyer for only some of the FHC’s assets can be identified prior to triggering the OLA
It’s likely that a prospective buyer of one or more of the primary entities (i.e., the broker-dealer and the commercial bank) will insist on leaving behind a portfolio of problem assets — for Bear Stearns, it was a $30bn pool of assets that JPMorgan left behind; for Lehman, it was a $62bn pool of assets that Barclays was originally going to leave behind (before the FSA torpedoed the deal, of course). To do this, the FDIC would likely do one of two things. The first option would be to enter into a “loss sharing P&A,” in which the buyer would acquire all of the FHC’s assets, but the FDIC would agree to absorb most of the losses (>80% usually, I think) on a fixed pool of assets.
The second option would be to “bridge” the FHC and the relevant entities being acquired, then sell the pool of problem assets back to the receivership, and then sell the good assets to the buyer. Section 210(h) of Dodd-Frank authorizes the FDIC to create a “bridge financial company” — a temporary, pop-up financial institution that automatically has all the necessary charters and licenses, and is run by the FDIC — to purchase selected assets and liabilities of the entities in receivership. Crucially, before a broker-dealer is handed over to the Securities Investor Protection Corporation to resolve, the OLA allows the FDIC to transfer assets and customer accounts from the broker-dealer to a bridge financial company. This will allow the FDIC to ensure that the full suite of key services can continue uninterrupted: depositors can have uninterrupted access to their bank accounts, prime brokerage clients can have uninterrupted access to their cash and securities, etc.
Moreover, if a buyer can be identified ahead of time, the FDIC can prevent the bank’s derivatives counterparties from seizing the bank’s posted collateral and liquidating it at fire-sale prices (which they’d be allowed to do immediately under the Bankruptcy Code). Section 210(c) prevents derivatives counterparties from terminating the contracts and seizing the collateral for essentially a full business day after the FDIC is appointed as receiver, during which time the FDIC can transfer the derivatives to a bridge financial company. If the FDIC can sell the bank’s derivatives to another financial institution or a bridge financial company within one day, then there will be no interruption in the bank’s derivatives book.
The key, in my opinion, to making this work is that the OLA allows the FDIC to bridge not just the holdco and the primary entities being acquired, but also any booking entities that engage in significant intercompany transactions with those primary entities. This allows the FDIC to avoid the kind of endless intercompany disputes that have absolutely plagued the Lehman bankruptcy. If assets need to be shifted among the booking entities and the primary entities in order to minimize the disruption to clients, or to pave the way for a sale of the entire broker-dealer (and with it the entire “trading book”), then the FDIC has the discretion to get that done.
Now, what would happen to unsecured creditors? That depends entirely on what liabilities the buyers are willing to assume. In normal commercial bank resolutions, the P&A usually includes the senior unsecured and subordinated debt. This was famously not the case with WaMu, where the P&A with JPMorgan left the senior unsecured and subordinated debt holders out in the cold. This came as a huge shock to the market, and we can debate whether or not it was the right move by the FDIC at the time, but one indisputable benefit is that it created a precedent for haircutting senior unsecured and sub debt. Market participants won’t be nearly as shocked if the FDIC does that again.
In any event, I think the FDIC could certainly allow third-party buyers to leave the senior unsecured and sub debt behind without causing a systemic meltdown. The FDIC has the tools to ensure that the bank’s key services continue uninterrupted, which will prevent most of the contagion from spreading. Past that, I don’t really care if unsecured creditors get a haircut.
(3) Potential buyers have been identified, but no agreement has been reached by the time the OLA is triggered
This type of situation is the reason the “bridge bank” option was created back in the S&L crisis, and the bridge financial company option can be used here. The FDIC would likely bridge the FHC, the primary entities that potential buyers are interested in, and any booking entities that engage in significant intercompany transactions with those primary entities. It would be necessary to bridge the key booking entities here in order to prevent any derivatives counterparties from terminating the trades and seizing and liquidating the collateral, which could easily kill any potential sale of the primary entities or holdco.
If it’s starting to look less and less likely that a deal will be reached, the FDIC can start taking steps to minimize the disruption to the markets , like allowing prime brokerage customers to transfer their accounts to other brokers, and allowing derivatives counterparties to novate trades to other dealers. If a deal is struck, however, the bridge companies would transfer the assets being acquired to the buyer, and sell whatever is left back to the receivership.
(4) No buyer can be or will ever be identified
Next stop: Liquidation Station! Honestly, this scenario strikes me as extremely unlikely. You need to have a business that’s important to the functioning of the global economy just to be eligible for resolution under the OLA in the first place, so any company being resolved under the OLA is almost by definition going to have value as a going-concern. Anyway, in the unlikely event that this scenario did occur, the FDIC could keep the assets off the market for a good 2 years, and possibly even longer if necessary, as bridge financial companies have a 2-year life under the OLA, with an option for extensions. Again, it would bridge the FHC and its subsidiaries, and sell the assets off over time, avoiding a messy fire-sale that could depress asset prices and transport the bank’s problems to other financial intermediaries.
What about all those thorny international problems? Well, the truth is that in terms of systemic risk, there’s only one other jurisdiction that really matters: the UK. New York and London are still the two dominant financial centers, and the vast majority of transactions at the major US banks flow through either New York or London. It’s important to understand that it was the UK’s
I’m not claiming that the Dodd-Frank resolution authority is perfect by any stretch of the imagination. But I think it absolutely provides the FDIC with the tools necessary to resolve a major US bank in an orderly fashion, and that, understanding this, regulators would indeed use the OLA to resolve a major US bank.