Addressing Too Big to Fail: Resolution of SIFIs - Transcript
Panel Session Highlights with:
Ron Feldman, Federal Reserve Bank of Minneapolis
Arthur J. Murton, Federal Deposit Insurance Corporation
Kenneth E. Scott, Stanford University
Eugene Ludwig, Promontory Financial Group
Ron Feldman: I think all of us who are interested at all in "too big to fail" know that the issue of breaking up institutions has again attracted a lot of attention, as it does periodically, and my own sense is that the resolution regimes that we're going to be talking about today are really substitutes for the idea of trying to address too big to fail by breaking the firms up. And therefore, in my mind, the degree to which the various options that are going to be discussed today are not viewed as credible or not viewed as effective, ultimately the direction I think we'll end up going is, in fact, heading down the road of some sort of breakup of firms. It's an issue I've written on and I personally don't think that will largely be effective. So I would hope that these regimes that we're going to talk about ultimately are more effective.
Arthur J. Murton: When policymakers faced the crisis in 2008, as Andy Haldane [Bank of England executive director of financial stability] mentioned yesterday, they faced some really unappealing choices. The decision could be made to bail out shareholders and creditors, or to allow this process to unwind, let certain firms go into bankruptcy, and whatever that might entail. And I think it's fair to say that when faced with such a choice, policymakers are going to be inclined to choose the bailout option. And so I think what Dodd-Frank tried to do was to address that in two ways, by, one, making it less likely that policymakers will confront that choice, and secondly, that if confronted with it, they actually have another option that would be preferable to either allowing the firms to unwind through bankruptcy or bailing out shareholders and creditors.
And so, what you have in Dodd-Frank is you've got many acts, many titles, dealing with market reforms, consumer protection, mortgages, and so forth. Title I and Title II are the two that we'll be talking about today. Title I is more about lessening the likelihood that we'll confront a crisis; it sets up the FSOC, the Financial Stability Oversight Council, gives the Federal Reserve heightened credential standards, and so forth. It also is the place where resolution plans are required. Title II is the orderly liquidation authority that was given to the FDIC [Federal Deposit Insurance Corporation].
So let me talk about the orderly liquidation authority that was given to us in Title II.
So this is just a simple diagram of what's going on (referring to slide): you've got on the left, initially, the holding company, the parent holding company; as I said, you have banks, broker dealers, whatever else subsidiaries. They're placed into a receivership and a bridge holding company is created, and so virtually all of the assets of the parent company are transferred to the holding company. Some of the liabilities are transferred, but certainly the equity, subordinated debt, and some of the senior debt is left behind in the receivership. After the bridge operates for a period of time, there's a conversion of those claims in the receivership into the equity and ownership of a new co-holding company, and that's the entity that comes out of this process. And again, there may be certain requirements to spin off parts of the operation.
This is an example of how the capital stack might work, how the loss absorption might work. On the left you've got what it looks like at failure, you've got $85 billion in equity, subordinated debt of $39 billion, and close to $200 of senior unsecured debt. Over on the right, if we assume that there's $130 billion of loss, you see that that's enough to eliminate the equity and the subordinated debt and you see it just barely eats into the unsecured debt. What happens then, some of that unsecured debt is converted into equity of the new company. One possibility is to also create some new convertible subordinated debt just in case the initial equity isn't sufficient. Then you can leave some of the senior debt in the same form as senior unsecured debt.
So that's how the approach would work. What we like about this approach is that it does provide for accountability. You hold the parties responsible; the top-level management would be replaced, the culpable management. The shareholders and creditors of the parent company would be exposed to loss and required to absorb that loss, and at the same time it would allow operating subsidiaries to continue, which means less disruption to the financial markets and to the financial system and to the real economy. It allows an entity to emerge that is viable and is able to be resolved under bankruptcy and is not systemic.
Eugene Ludwig: There were, to my mind, two key elements that made Lehman so destructive. The first is the most obvious: a lack of confidence in the prompt funding of counterparty claims across a global network of subsidiary operations. As Art [Murton] said, the FDIC's single point of entry approach targets this exact issue, making sure that the essential operations of the company continue as normal. It minimizes contagion and it imposes first losses on those who are responsible for governing the consolidated entity. Not on the creditors, depositors, and employees of the day-to-day businesses; in other words, it starts where it should start, taking a haircut initially where it should take a haircut, and then moving into more complex issues.
The second element, however, was fuel for the first, and that was the chaos of the resolution itself. When it came to resolving or selling large financials, the motto of the financial crisis, in my view, was sort of, "Do it over the weekend." What was really remarkable, as many of you remember, it seemed to be that there were these busy weeks and then everything blew up over the weekend. Regulators and investors were forced to sort out complex risk-sharing legal entity and business line structures in a matter of hours. They had to disentangle operating relationships that were sometimes not fully clear to the company itself and they did an admirable job (indeed, a remarkable job) under the circumstances. But with better information and more time, the ultimate outcome would almost certainly have been less disruptive.
Single point of entry gives visibility as well, and, importantly, to investors it provides a clear, predictable outcome for the essential operations of global institutions. And as an aside, I'd like to emphasize that while the process that Dodd-Frank has set up in the resolution recovery area is in and of itself a value, the nice thing about what the FDIC has been doing in single point of entry, it's not just about process, it's really about outcomes as well, which is absolutely critical. Here disclosure is the public's best friend.
The FDIC is in a strong position to work with foreign supervisors to minimize the chaos disruptions and considerable loss that emerges when fear takes over and untried processes lead to grabbing of assets and excessive ring-fencing, if you didn't have this kind of mechanism; because the fact of the matter is, as I thought Ken [Scott] said so well, there is just natural jurisdictional difficulties that are baked into a multinational system, and here working with regulators, knowing regulators across borders, makes a huge difference in getting a step forward in that [what] the FDIC's done with the Bank of England is just terrific.
Kenneth E. Scott: John Taylor [Stanford University economics professor] talked last night about a proposal for a, we've called it Chapter 14 of the bankruptcy code, which has been developed by a group centered at Stanford called The Resolution Project that began in 2009 when Congress was in the midst of debating financial reforms.
Chapter 14 is a special chapter for financial companies only. It is a portal for financial companies to enter into Chapter 11 proceedings; reorganization or Chapter 7 proceedings; liquidation. Second, coverage. As it stands, we're proposing coverage of all financial groups with over a hundred billion [dollars] in total assets. A third feature of the new chapter is that it incorporates an explicit rule for supervisors. The primary regulator supervisor can initiate a filing, can participate in any existing proceeding, but not control it as simply an administrative process with no participation rights for creditors. The fourth distinctive element is judicial oversight—that's distinctive with respect to Title II—management can initiate a voluntary filing, including a prepackaged reorganization… creditors are recognized as formal participants, and some actions are to require creditor approval or judicial approval, or both; and finally we set forth some new provisions to try to facilitate reorganization of financial institutions.
The second type of systemic risk is what you can call "common shocks": things that are felt by, that affect, many institutions together. I think that's what we were looking at in the panic and crisis of 2008; there had been a growing concern over the ending of a real estate bubble and the fall and the effects of that on the value of subprime mortgages and trillions of dollars of securitization tranches. All through…problem signs (as was pointed out earlier) could be seen earlier—they were certainly growing in clarity throughout 2008, but they came to a head in 10 days in September. In those 10 days, Fannie [Mae] and Freddie [Mac] were put into government conservatorship; Merrill-Lynch was acquired—forcibly. Lehman Brothers Holding filed for bankruptcy. The Fed made the large loan to AIG. That's quite a lot of common shocks hitting all at that one time.
We had at that point dozens of financial institutions around the world uncertain of each other's solvency.
And this I think is sort of the ignored gorilla on the policy stage of systemic risk. Is this type of systemic risk—common shock—the focus of Dodd-Frank Titles I and II? No. Is it the focus of Chapter 14? No. It's beyond the reach of the bankruptcy code, to deal with this kind of a problem.
Feldman: OK, so let's get right to the questions. So, I would say for the benefit of the panelists who don't see them, I'd say one theme of the questions is, "I heard what you said, but I don't think this is going to work."
I think there are at least four things that people raised: the institutions are too big; they're too international; the human resources are not going to be able to be brought to bear to effectively do a resolution; and many of them are going to fail at the same time. So why do you remain confident despite these impediments?
Murton: Sure, well, let me start by saying those are all good questions, those are certainly the challenges that we confront in this process. And we have a lot of work to do ahead of us to address those. But I think when you compare where we were in 2008, or pre-Dodd-Frank, the authorities we had and the thinking that had gone into it, and the discussions that had taken place across agencies and across jurisdictions, I think we are in a far better position than we were then, which isn't to say we don't have more work to do.
Certainly, finding the management to run the firm is a challenge; we are required, and would want, to remove culpable management—that doesn't mean all management, it's been our experience in the past that some (much) of the management stays in place and continues to operate it—but we do need to find new CEOs, likely, new board, and we have been thinking about how to approach that. But we know that's one of the challenges.
Feldman: Do you want to take up the multiple failures at the same time?
Murton: Multiple failures—that is a challenge. Predicting the future and what scenario we're going to confront, that's a difficult thing to do. We think we could handle multiple failures, but there are scenarios in which some kind of some other authorities that are still available might need to come into play, so again, we're going to continue working toward addressing these and we realize we have a ways to go.
Feldman: Great, OK, Gene, so again: too big, too international, not enough human resources, and too many failures at the same time. How would you take on a couple of those?
Ludwig: Well, it seems to me that, obviously, whatever happens will be messier than we expect—that's the way life really works, but I think we beat ourselves up a little bit too much in terms of how we got through this last crisis where we had, as Art said, nothing. We go into this crisis, after a long period of well-being, with scant data, inadequate authorities, no focus in this area hardly at all, and at this kind of magnitude; and yet we got through this on our feet not well, so we need these new tools.
The new tools are profound; whether it's stress testing that the Fed's doing, which is in some ways part of this whole stew of improving the situation and then resolution recovery plans, we have a much more profound set of available data than we did before, and that's point one. I think the second thing, which I think can't be overstated, is that the FDIC's historic experience dealing with individual institutions and through the thrift crisis dealing with multiple institutions has been really amazingly successful. What it hadn't had is a holding company authority. And while there are differences there, they're not so profound.
Feldman: So, a round of applause for our panel.