Treasury Proposes Dubious, Untested Chapter 14 Bankruptcies for Too Big to Fail Banks

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.

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