By John Bovenzi, Randall Guynn and Thomas Jackson
The “too-big-to-fail” problem took center stage in 2008 when it became clear that both the bankruptcy process and financial regulators were ill-prepared to handle the failure of systemically important financial institutions (SIFIs). The Dodd-Frank Act was passed three years ago to provide the regulators with new powers to solve this problem. Yet, there’s no agreement on the basic issue of whether the Dodd-Frank Act ended too-big-to-fail or institutionalized it.
Working as part of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative we have studied this issue in detail and conclude that we are on the right path to ending too-big-to-fail and importantly doing so in a way that precludes government bailouts.
Alternatives are needed
The too-big-to-fail problem arises if the only choice policymakers have when a SIFI fails is between bailouts and collapse of the financial system. Policymakers need an alternative that allows a SIFI to fail and be dealt with in a way that does not risk a financial collapse and without taxpayer bailouts. The important work of developing the answers is underway.
The FDIC has proposed using its new powers through a “single-point-of-entry” (SPOE) approach. Under this plan, the SIFI’s top-tier parent would be closed upon failure. But all of its assets (including its ownership of subsidiaries) would be transferred to a newly established “bridge” holding company along with short-term debt and other operating liabilities. Long-term unsecured debt would be left behind to absorb losses.
The FDIC’s SPOE approach has great potential for ending too-big-to-fail. But to succeed, a number of steps need to be taken by regulators.
First, the FDIC needs to clarify that long-term unsecured debt is subordinate to short-term debt. We propose one year as the dividing line.
Second, the FDIC needs to confirm it will use the SPOE approach. Specifying a “presumptive path” provides greater predictability to the market and foreign regulators.
Third, to ensure that the private sector – not the taxpayer – bears all losses, SIFIs must have sufficient loss-absorbing capacity. Enacting substantial minimum loss requirements would ensure that all losses could be borne by shareholders, long-term unsecured creditors and other holders of capital structure liabilities, and not by taxpayers.
Finally, we need to distinguish between the government providing bailouts and serving as lender of last resort. This critical distinction is between providing capital to absorb losses and providing temporary, fully secured liquidity to stabilize the financial system. The vast majority of experts across the ideological spectrum, including the late Milton Friedman, correctly view the provision of secured liquidity to get through periods of financial stress as a temporary stabilization measure, and not a bailout.
Clarifying the bankruptcy process
It is important to improve the bankruptcy process itself. Bankruptcy is the preferred path for handling most failed institutions. The new authority under the Dodd-Frank Act is only meant to be a last resort.
In fact, the FDIC’s approach should be integrated into the Bankruptcy Code. This can work through a Chapter 11 proceeding commenced solely with respect to a parent holding company. The group would be recapitalized through the transfer, under Section 363, of the holding company’s assets as well as certain liabilities (but not long-term unsecured debt) to a new holding company comparable to a bridge financial company under the Dodd-Frank Act.
A source of interim secured liquidity will be needed since even a solvent new holding company may not be able to access the private sector credit markets right away. That is why the Dodd-Frank Act included the Orderly Liquidation Fund, which can provide secured lending; we believe access to the Federal Reserve’s discount window can create a similar situation for the new holding company created out of bankruptcy. Finally, a temporary automatic stay preventing counterparties from terminating financial contracts will ensure that there will not be a Lehman-type disorderly termination of contracts and fire sale of related collateral. Similar automatic stays need to be enacted into law in other countries.
Fundamental to ending too-big-to-fail is having a transparent process in place that allows SIFIs to fail without destabilizing the financial regulatory system to the benefit of our economy. The measures outlined here would create such a process, resulting in greater convergence between the Bankruptcy Code and the Dodd-Frank Act’s Orderly Liquidation Authority and making it possible to deal with failed SIFIs in ways that meet the twin goals of preserving financial stability and eliminating taxpayer bailouts. That is the right path to solving the too-big-to-fail problem.
John Bovenzi is a Partner at Oliver Wyman, Randall Guynn is a Partner at Davis Polk, and Thomas Jackson is a Professor at the University of Rochester. They are co-chairs of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative’s Failure Resolution Task Force.