The Trump Treasury has proposed changing Dodd Frank rules, supposedly to make resolving Too Big to Fail banks easier.
The Treasury yesterday proposed replacing the resolution scheme under Dodd Frank, called the Orderly Liquidation Authority, confusingly also called Title II liquidations, with a new type of bankruptcy, Chapter 14. While there was a lot not to like about the OLA, Chapter 14 is no better and in key respects, markedly worse.
The costly fallacy underlying Chapter 14 is the idea that big banks can be wound up without a taxpayer backstop. And despite Treasury’s chest thumping that taxpayer monies won’t be at risk, in fact, government funding is still available if needed.
And like it or not, that makes sense. The reality is that banks provide critical infrastructure for commerce, known as a payment system. Recall that in the crisis, the authorities had to guarantee money market mutual funds up to $250,000 because the Lehman implosion brought down the Reserve Fund, precipitating a run on mutual funds. Mutual funds are big participants in the repo market, which is critical for financing the trading of banks and large investors.
We’ve embedded the Treasury proposal at the end of this post. Note that some measures could be implemented by regulators directly, but the Chapter 14 scheme requires Congressional approval.
Chapter 14 is not a new idea. It was originally proposed by the Hoover Institute and made it as far as a Senate bill which was not passed in 2013.
At a high level, under Chapter 14, the assets of a failed bank would be transferred to a new entity. Shareholders and unsecured creditors would be left behind. Solvent subsidiaries, “such as broker-dealers, insured depository institutions, and overseas subsidiaries” would continue to operate as normal. The proposal discusses giving banks less support during the resolution process to the new entity by relying on private lenders as much as possible for the bridge bank (bankruptcy “debtor in possession” lenders) and using guarantees in place of loans whenever possible.
Observers gave the proposal mixed grades. It does allow for a bit longer suspension of termination rights by derivative holders than the OLA did, which would facilitate the sale of swaps books to new owners. But it restricts the flexibility of the FDIC in dealing with creditor. And it also gives the failed banks more rights in court. As the Financial Times noted:
“The FDIC needs discretion to restructure a company. You can’t say in advance that the FDIC has to follow a completely pre-written rule book,” Mr [Marcus] Stanley [of Americans for Financial Reform] said….
[Former Treasury official] Mr [Aaron] Klein expressed concern over a Treasury proposal to give financial institutions more power to challenge liquidation decisions in the courts. “One thing the financial crisis made clear is there are plenty of financial companies that care more about trying to preserve their value than preserving the entire system,” he said.
My question is over the treatment of depositors. The report makes very little mention of them. It appears to assume that they won’t come up as a resolution issue because deposits will sit in depositary subsidiaries that will be solvent.
However, regulators have allowed large derivatives players to finance their derivatives positions using deposits. If a Too Big to Fail bank collapsed in part because it was sitting derivatives bets gone sour, that means the depositary could be insolvent. The depositors’ fallback would then be the FDIC. Recall that the FDIC was at risk of running out of funds during the crisis. It was understood then that the FDIC would get an injection from the Federal government if it needed one. Presumably, even an ideologically-oriented Republican administration would do so. But that would not be consistent with the spirit of this Dodd Frank revamp.
In addition, recall that depositors with over $250,000 at a single institution are at risk. You might say it’s silly to have that much at one bank, but small business owners with decent-sized payrolls can’t avoid that. They need to have sufficient funds around payroll time at a minimum, and they also need cash in the till to pay for orders or other supplies. It is not operationally viable for a business with meaningful cash in and outflows to have a large number of small checking accounts. But the exposure is real, even if the odds of losing are small. Recall that when IndyMac collapsed, deposits over the FDIC insured limits took ~90% hits.
Finally, the proposal presents the picture that there will be enough debtor-in-possession financing to support the bridge bank, and at worst guarantees will do the trick. However, it keeps in place the ability for the Feds to provide the needed support. And there’s good reason why. From Steve Lubben at the New York Times on the 2013 incarnation of the Chapter 14 plan:
….the Chapter 14 proposal has what can only be called a ridiculous financing mechanism. I have previously noted the dubious assumption in Chapter 14 that private debtor-in-possession financing will be available in times of financial distress, especially in the size a large financial institution would need.
Lubben was also irate that the version of Chapter 14 he commented on contained perverse incentives. There weren’t enough details in the the Treasury scheme to be certain those ideas weren’t part of the plan, but enough verbiage was spend on inducing private lenders to step up that it appears not.
So despite all the handwaving about taxpayers not being the hook, they most assuredly are:
Treasury recommends, however, that Title II remain as an emergency tool for use in extraordinary circumstances. Bankruptcy should be the resolution tool of first resort, but even the improved Chapter 14 bankruptcy process may not be feasible in some cases for large, complex, cross-border financial institutions. If sufficient private financing is unavailable, OLA may prove necessary to avoid financial contagion while at the same time allocating losses to shareholders and creditors based on a clear, predictable hierarchy of claims.
Treasury contends that it will minimize risk by lending only against “sound” collateral and/or by charging a premium interest rate.
As we have argued repeatedly, banks enjoy such extensive subsidies from government that they should not be treated as private entities but should be regulated as utilities.
An additional problem that no one wants to admit to is that absent creating an supra-national authority and legal regime for world-straddling banks, there is no tidy, surgical way to put down a failing bank with major international operations. Any US laws will cover only US activities. In the Lehman collapse, there were conflicting US and UK court rulings. Legal observers contended that Judge Peck, who was overseeing the US bankruptcy, overstepped his powers and that his lack of deference to foreign courts did not go unnoticed. They expect foreign regulators and judges to be much more aggressive in protecting their interests in the event of another US megabank failure.
The one bit of good news here is that this proposal does not seem likely to get done. Jeb Hensarling, the influential head of the House Financial Services Committee, doesn’t like it because it still allows for taxpayer funding. Fed chair Jerome Powell is opposed to getting rid of taxpayer support. With key players at odds, it’s likely that the flawed OLA remains in place.
It would therefore be nice to see the authorities be more serious about leashing and collaring banks, since they are not in a much better position than they were pre-Lehman about managing a big bank collapse. And recall that Lehman, at a mere $660 billion in assets, was deemed only to be “mid sized”. But DC remains in thrall to the financial services industry. It will take another crisis to have a shot at real financial reform.OLA_REPORT
“…The reality is that banks provide critical infrastructure for commerce, known as a payment system.”
How about we start treating this portion as the utility it is.
Um, did you not see I recommended that? I would add the deposit function.
Yves … I find myself agreeing with you all the time.
Banking infrastructure as an excuse for TBTF is a trigger for me … “No”
Excellent post, Yves.
What other sites would you recommend for both basic education and current coverage of the banking spectre haunting all of us. Do you have any favorites in your blogroll?
Does anyone have recommendations where any of us might most effectively weigh in with legislators or other officials to improve the ideas and legislation being floated?
I suppose that this is not so surprising when you consider the fact that it was introduced under the Presidency of a man who has used bankruptcy several times in his business career to shake off debts. Having this measure pushed through that is more ‘sympathetic’ to the bankrupt entity, in this case big banks, will probably help get the big banks more on his side for the rest of his Presidency, whether it be three or seven years. That would be a lot of firepower lined up behind him at the next election so this could all be part of a political calculation. After his Tax Bill went through the corporations certainly looked at him with a more kindly glance.
As Yves observed, preemptive requirements to prevent the types of situations that we were presented with in 2008 remain largely unaddressed. The political current underlying this legislation is about locking in and perpetuating the TBTF status quo. Due to the failure to address the linkage issues that we saw in the bailout of AIG and its Wall Street counter-parties, booking derivatives in the FDIC-insured bank subsidiaries of these large, opaque, and intentionally complex bank holding companies practically guarantees a major systemic issue will develop in an environment of volatile financial markets. Rather than continuing to give the individuals who run these institutions a blank check with which to speculate for private gain with a public money backstop, whether from the taxpayers or the Fed, reinstate the Glass-Steagall Act and break these companies up. Treat and regulate their depository and payments system function like the public utility service that it in fact is. The asset side of their balance sheets can be populated by US Treasury and Agency bonds at their core.
Unsurprising that an administration riddled with Wall Street representatives, including the Secretary of the Treasury and the National Economic Advisor, would be proposing this legislation. Those bankers who want to speculate either domestically or across national borders can do so with their own money and that of their bondholders and shareholders. There is little reason I can see why unwinding such operations would not be addressed under the existing US bankruptcy code and that of foreign jurisdictions.
Does anyone know if any part of this proposal affects risks of having large sums of money in MM funds today? Don’t MM Funds such as those at Vanguard and Fidelity use large Wall Street banks like BNY Mellon as depositories? What are the protections here for fund owners?
I think one can safely say that the takeaway from this article is that there is no solution. Seems that people just refuse to question the current banking system and prefer, instead, to patch up this fundamentally flawed paradigm – a holdover from more than a century ago. Banks should provide one function and one function only, sound underwriting.
On the other hand, efforts such as the NEED Act and other international initiatives address the need to completely revamp the banking system so that none of the pathologies such as those expressed in this article would exist. One cannot regulate an inherently dysfunctional system. Economists such as Joseph Huber have outlined a clear path forward with none of the deliberately induced complexities of the current system.
Yves writes: “My question is over the treatment of depositors. The report makes very little mention of them. It appears to assume that they won’t come up as a resolution issue because deposits will sit in depositary subsidiaries that will be solvent.”
That’s my question, too.
I hope that is true but have learned from painful experience to assume nothing when it comes to the TBTF.
While I don’t have the financial chops to parse the following, I wonder if “no taxpayer bail-out” is another way of saying “Cypress-style depositor bail-in”?
So as far as you, the depositor, are concerned, your money in checking and savings accounts is the bank’s “unsecured debt.” You will have to stand in line behind trillions of dollars of derivative payouts before your checking and savings accounts will be made whole. Both the Bankruptcy Reform Act of 2005 and the Dodd Frank Act provide special protections for derivative counterparties, giving them the legal right to demand collateral to cover losses in the event of insolvency.
adding: Wasn’t incorrectly assuming the solvancy of AIG insurance as the financial backstop of derivatives and TBTFs one of the key failures of the 2008 crisis? (Note to self: never assume solvency.)
Thankfully, the majority of Americans have less than $800 in savings, and are basically living paycheck to paycheck which equates to a minimal FDIC outlay in the event of a crisis.
Why not just put a limit on how big the banks can be, and require them to sell pieces or subdivide when they exceed it? All this dancing around the obvious solution gets very tiresome.
Break them up now, before they blow themselves up again.
You don’t prepare for a hurricane when the wind is already howling. You don’t prepare for an earthquake when the ground is already shaking. You look at the setup, you look at the risks, and you trim the excess risk before the crisis hits.
Any bank that is “too big to fail” is “too big to exist”, and now that the crisis has passed it’s time to spin them off, avoid the massive conflicts of interest created by mingling lines of business that don’t belong together, and get the taxpayers and the depositors off the hook before the next wave of banking stupidity.
It probably suits the treasure to have a few TBTF banks. Easier to have a conference call when fixing things.
Disclaimer: This comment is deliberately ambiguous.
Because everyone else is cheating, and we can’t be out-cheated.
You really only have to read up on the issues and problems hammering out the Basal banking accords to see the protectionist attitudes among the banking communities.
Can student loan defraudees incorporate them self as a new entity and escape mandatory repayment for useless degrees?
Or would Biden be against that too?
Seems appropriate to revisit this free and sage bits of wisdom.