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The New York Fed?s William Dudley gave a surprisingly candid, meaning not positive, assessment of the state of the Too Big to Fail problem in a speech yesterday at the Clearing House?s Second Annual Business Meeting and Conference. From the text of his speech (hat tip Richard Smith):
Because no plausible level of capital and liquidity standards will be sufficient to reduce the probability of failure to zero, it also makes sense to work on the other major margin?to reduce the cost of the failure of a large, complex financial firm. We can do this by making changes so that such failures are less likely to impair the functioning of the broader financial system. In this area, although many initiatives are in train, I would conclude that we are still very far from where we need to be.
Dudley then tells the audience that there are some constraints in Dodd Frank on the ability of systemically important firms to get bigger (but he?s clearly hoping, rather than certain, that these measures will be effective). He also says the Fed is in the process of mapping interconnectedness. This is a really important measure. I had asked why this wasn?t made a top priority as soon as Bear was rescued, because the reason for preventing a collapse was no one had the foggiest idea of how bad the collateral damage would be (pun intended). I suppose four years late is better than never.
Back to the speech (emphasis ours):
Work is also underway to evaluate what changes would be required to make the future bankruptcy of large complex firms less disruptive, while also developing an alternative means for the orderly resolution of such firms outside the normal bankruptcy process.
The costs to society of large complex financial firms failing can be reduced at least to some degree by having firms, working in conjunction with their regulators, ?pre-plan? their own failure through the so-called ?living will? process. The largest and most systemically important banks submitted their ?living wills? to the Federal Reserve and the FDIC this summer. We have reviewed the first iterations of their plans and are currently drafting feedback for the firms to incorporate in their next submissions. Through such ?living wills,? regulators are gaining a better understanding of the impediments to an orderly bankruptcy. This is the necessary first phase in the process of determining how to ameliorate these impediments over time and then doing so.
In my view, this initial exercise has confirmed that we are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society. Significant changes in structure and organization will ultimately be required for this to be achieved. However, the ?living will? exercise is an iterative process, and we have only taken the first step in a long journey.
The second way to potentially minimize the negative externalities from a firm?s failure would be to avoid a bankruptcy proceeding altogether and instead resolve the firm under the Dodd-Frank Act?s Title II orderly liquidation 7 authority.8
The ?single point of entry? model has much promise, but much remains to be done before it could be implemented with confidence for a globally active firm. Title II authority is U.S. law. Subsidiaries and affiliates chartered in other countries could be wound down under the bankruptcy laws of those countries, if authorities there did not have full confidence that local interests would be protected. Certain Title II measures including the one-day stay provision with respect to OTC derivatives and other qualified financial contracts may not apply through the force of law outside the United States, making orderly resolution difficult.
The fact that the US firms can?t be put into bankruptcy gracefully (and that the living will process is at this point an exercise for regulators to look at the legal plumbing) isn?t exactly surprising. And it should come as no surprise that Dodd Frank?s orderly resolution authority runs into serious shortcomings with firms with big foreign operations. Administration defenders pooh poohed our reservations which we stated over a year ago and tracked Dudley?s. Bankruptcy is always national, and foreign regulators could put foreign subs into bankruptcy (the odds of that are if anything higher than before; foreign creditors were treated shabbily by Judge Peck in the Lehman bankruptcy, so a foreign regulator might want to get out in front of US regulators if at all possible. And this wasn?t just our view. From a May 2011 post:
For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it ?recognizes the strong likelihood of ring fencing in a crisis? due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that ?helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.? In other words, it accepts a national process as inevitable and recommends dealing with that reality.
But not to worry. Spencer Bacchus pointed out in a paper his office published last month, that despite the claims of Dodd Frank fans that it barred bailouts, he showed how there is still plenty of room for rescues:
Among other things, the ?resolution authority? gives the FDIC the power to lend to a fail- ing firm; purchase its assets; guarantee its obligations; and ? most important ? pay off its credi- tors. The ?resolution authority? also gives the FDIC the authority to borrow money from the Treasury. Lots of it. How much? The FDIC can borrow up to 10% of the book value of the failed firm?s total consolidated assets in the 30 days immediately following its appointment as receiver. After those 30 days, the FDIC can borrow up to 90% of the fair value of the failed firm?s total consolidated assets.
So while at least stockholders would get wiped out, we seem to have institutionalized the Geithner put: ?no bank bondholder will take any losses.? Dudley account of all the things that need to happen to solve the TBTF problem in the close of his speech make clear we aren?t close domestically and even less close on the international front. So expect more stealth and probably overt big bank salvage operations in your future.
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