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The Dodd-Frank mandate for large financial institutions to file annual Orderly Resolution Plans has been a total wasted effort. Aside from the fact that these plans are not credible, the real systemic risk issue is not bankruptcy, but the broken FDIC resolution process for large banks. History shows that the FDIC cannot efficiently resolve a large bank unless it sells the bank to a larger healthy institution. Whole-bank purchase resolutions are what created many of today’s “too-big-to-fail” institutions. Instead of focusing on holding company bankruptcy reorganization, the best use of annual Orderly Resolution Plans is to require the FDIC to plan for an efficient break-up of the largest banks in the FDIC bank resolution process.
If there were a credible process for breaking up large failing banks, Congress could easily raise the Dodd-Frank bank holding company designation threshold from $50 to $250 billion. This would free most of the nation’s regional banks from costly and intrusive Federal Reserve Board enhanced prudential supervision and regulation. The failure of a single institution smaller than $250 billion can in no way threaten the stability of the US financial system, but if they are sold intact when they fail, they compound the too-big-to-fail problem.
Title I of the Dodd-Frank Act requires that all bank holding companies with more than $50 billion in consolidated assets and non-bank institutions designated by the FSOC be subjected to heightened prudential supervision and regulation by the Federal Reserve Board. They are also required to file annual Orderly Resolution Plans with the Fed and FDIC that describe a strategy for reorganizing the holding company in a Chapter 11 bankruptcy without causing financial instability. The Fed and FDIC are supposed to decide if the plans are credible, and if they are not, regulators are supposed to propose structural or operational changes that would make a smooth bankruptcy reorganization possible.
The recent House Financial Services Committee Republican Report discusses the flaws in these plans. Orderly Resolution Plans have been compared to pre-packaged bankruptcies, or blueprints for speedy reorganizations using bankruptcy that will keep financial institutions open and operating and thereby remove the risk of financial instability. On close examination, this analogy breaks down because these plans lack creditor participation. The key to a successful pre-packaged bankruptcy is creditor acceptance of a debt restructuring plan before entering bankruptcy. But creditors do not approve Orderly Resolution Plans. The plans are kept secret from creditors and the institutions filing the plans are not even obligated to follow them in bankruptcy.
Historically, when large banks fail, the FDIC arranges a whole bank transaction in which a larger, typically healthier bank, assumes all the deposits and most, if not all, of the institution’s assets. Sometimes the FDIC uses a loss share agreement to partially cover losses on the failed bank assets that are of questionable quality. A whole bank transaction was used to resolve WaMu, the largest bank failure in U.S. history, without cost to the deposit insurance fund.
The problem with whole bank resolutions is that they require a bigger, heathier bank to purchase the failing institution, and even when one exists, if a sale is successful, it creates a new larger institution. One step toward fixing the too-big-to-fail problem, is to require the FDIC to break up large failing banks when they sell them in a normal FDIC resolution.
There are costs associated with changing the public policy priorities imposed by Federal Deposit Insurance Corporation Improvement Act on the FDIC resolution process. Whole bank purchases impose the least cost on the deposit insurance fund because bidders value acquiring the entire bank franchise intact. It will be costly and require significant time and resources to separate and market large failing banks piecemeal. For example, it may be difficult to identify all bank operations associated with a single customer relationship, and more difficult yet to package these customer relationships into sub-franchises that are readily marketable. But the added resolution costs are costs that must be born to avoid creating too-big-to-fail banks through the resolution process.
To reduce the cost of breaking up large banks in an FDIC resolution, the FDIC should be required to use Title I orderly resolution planning powers to require organizational changes within the depository institution that would allow the institution to be more easily broken apart in a resolution. This may involve organizational changes to information systems, employee reporting lines or other processes to ensure that the bank has the capacity to conduct key operations in house and is not relying on venders or consultants in a manner that would inhibit the break-up of the institution in the resolution process.
There are many complicated and potentially costly issues that must be solved before a large bank could be successfully dismantled and sold in pieces in an FDIC resolution. However, these issues are merely a subset of the issues the FDIC must solve if it is going to undertake a Title II resolution of the largest, most complex and internationally active institutions and downsize them in the resolution process.
Paul Kupiec is a resident scholar at the American Enterprise Institute where he studies banking and financial sector regulation.
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