Not too big to fail: Has US crossed bank resolution Rubicon?

A growing number of policy-makers believe the too-big-to-fail problem is now a thing of the past in the US. But with key details on how the resolution mechanism will work still unclear, some believe that optimism may be misplaced. By Matt Cameron and Joe Rennison

If a big US bank suffered life-ending losses tomorrow, it would be a catastrophe for holders of its debt and equity, but no-one else – there would be no public bail-out, and no real threat to the health of its peers. That view has been gradually filtering into market prices over the past year (see box, The end of the TBTF funding subsidy), and some of the industry’s leading lights are now saying the same thing publicly: in the US at least, banks are no longer too big to fail.

“I believe we have crossed the Rubicon in the US,” says Wilson Ervin, vice-chairman at Credit Suisse in New York. “We have solved the biggest problem of the 2008 crisis, in the biggest market in the world.”

John Dugan, comptroller of the currency during the crisis and now a Washington, DC-based partner at law firm Covington & Burling, sees it the same way. “I think a failing bank could be resolved tomorrow. I think the process would be easier once they come out with clearer rules, as they’re supposed to do in the next six months, but I really think it would work. They have the tools to do it – to fail the company – and they have the resources to recapitalise the company,” he says.

The tools were granted in Title II of the Dodd-Frank Act, and are still being fleshed out by the Federal Deposit Insurance Corporation (FDIC), which would play the role of receiver in what is essentially an accelerated bankruptcy process. The resources to recapitalise the stricken firm would be provided by writing down equity and debt issued by its parent holding company – a so-called single-point-of-entry (SPE) approach that leaves the operating companies open for business and is well suited to the existing structure of US banks.

In October, Paul Tucker, a senior fellow at Harvard Business School, became one of the first big-name policy-makers to say the problem had been fixed for systemically important financial institutions (Sifis) in the US, shortly before stepping down as deputy governor at the Bank of England. On December 5, Jack Lew, the US Treasury secretary, agreed regulators will meet the test of ending too-big-to-fail.

But there are plenty of sceptics. Some of the more technical issues in the SPE approach remain unresolved – such as how a recapitalised group would fund itself, whether foreign regulators would play ball, and how minimum debt levels will be set – and there are more fundamental objections too.  

One of the doubters is Harvey Miller, a partner at law firm Weil, Gotshal & Manges in New York, who has seen what happens when the market loses confidence in a bank – he is the lead lawyer for the Lehman Brothers holding company. “I commend regulators for trying to find a way through this swamp, but it’s a fable to say the SPE mechanism, in which the operating subsidiaries will continue to function, will stabilise the markets. If a Sifi enters a resolution process, no matter how it is designed, it will impact the global financial markets. How deep that impact will be depends on a number of factors – for example, how long did the markets have to prepare for the application of the Orderly Liquidation Authority under Dodd-Frank? Is there a quick, credible plan for stabilising the operations of the enterprise and, particularly, the subsidiary entities? Are all pertinent regulators co-operative and co-ordinated across international borders? Unfortunately, a reprise of the famous Lehman weekend of September 13–15, 2008 will surely cause havoc in the financial markets.”

Others raise a different objection, but reach the same conclusion. “In designing the resolution mechanism, regulators have made the assumption they will only have to deal with an institution-specific event. However, because all big bank balance sheets are by and large the same, most crises tend to be systemic in nature. And if there is a system-wide failure, then all bets are off. Regulators will have no choice but to resort to a broad-based bail-out,” says Jim Millstein, chairman and chief executive of advisory firm Millstein & Co, and former chief restructuring officer at the US Treasury.

Despite those objections, SPE looks certain to be the chosen path for US regulators after the FDIC published a consultation paper on December 10, putting the mechanism at the heart of the so-called Orderly Liquidation Authority, the new receivership process created under Title II of the Dodd-Frank Act (see box, Title II decision-makers).  

So, how would it work in practice? The SPE method relies on the fact that large US banks typically already have a holding company structure. Under this model, the mothership raises equity capital and issues both senior and subordinated long-term debt. This is streamed down to the operating subsidiaries – banks, broker-dealers and futures commission merchants, for example – in the form of equity, and funding in either the form of deposits or loans.

If one of the operating subsidiaries incurs losses that imperil the group’s existence, the FDIC would be appointed receiver of the holding company only, while allowing the subsidiaries to continue operating. At the point of receivership, the FDIC will create a bridge company into which it will transfer the assets of the holding company, such as investments and loans in subsidiaries, while leaving the liabilities in receivership.

At that point, it gets spicy. The board of the bridge company – minus directors and officers who had been deemed culpable for the problems and sacked by the FDIC – would appoint independent experts to assess the size of the losses that need to be covered by the holding company investors, as well as work out the value of the clean bridge company. It would be up to the FDIC to sign off on these estimates, using valuations compiled by its in-house experts as a reality check. “Due to the nature of the types of assets at the bridge financial company and the likelihood of market uncertainty regarding asset values, the valuation process necessarily would yield a range of values for the bridge financial company. The FDIC would work with its consultants and advisers to establish an appropriate valuation within that range,” the FDIC’s December 10 consultation paper says.

These values will enable two critical steps to be taken. First, holding company investors will see their shares and bonds wiped out until losses have been fully covered. Second, to put the bridge company on a sound footing, a portion of the remaining holding company debt will be converted into equity in the new entity. In case the new firm later proves to have been undervalued, the FDIC consultation paper says it may give holding company claimants warrants or options that would allow them to acquire additional stock in the bridge company (see box, Title II: securities-for-claims exchange).

This is a lot better than the existing toolkit, says Michael Krimminger, partner at law firm Cleary Gottlieb Steen & Hamilton in Washington, DC, and former general counsel at the FDIC. “The SPE mechanism for US bank holding companies, being an alternative to the chaos that would reign if regulators tried to resolve a Sifi under adjudicatory insolvency proceedings, is a great improvement because it allows regulators to control systemic risk, take quick action, provide liquidity and force losses on to shareholders and creditors of the failed firm. It is a huge improvement over where we were in 2008, where the actions taken were done so because there was no alternative,” he says.

But until it’s been shown to work, there will be questions. One of the biggest is how the bridge company – or NewCo in the FDIC consultation paper – will fund itself. The starting assumption of SPE is that the new company should be just fine, given the fact that losses will have been covered, assets will far outweigh liabilities and capital will exceed regulatory minimums.  

Millstein & Co’s Millstein does not expect it to work that way. “Unlike a manufacturing or non-financial firm, a bank’s inventory is money – it can’t function without cash – and at the start of what is in essence an insolvency proceeding, anyone who can take their money will do so. Short-term creditors do not hang around – why take the risk? Look at Bear Stearns: its repo counterparties did not stick around. When the firm was bought by JP Morgan, it had $25 billion in high-quality repo-able assets but no cash because no-one would lend it money against those high-quality assets,” he says.

As such, the FDIC has a back-up plan. If no private sources are willing to lend to the bank, the FDIC might provide guarantees or temporary advances from what is called the Orderly Liquidation Fund (OLF), in which emergency funds are provided by the US Treasury. This might look suspiciously like a public bail-out, but law prevents the taxpayer footing the bill under any circumstances. That means all liquidity must be fully secured against assets belonging to the bridge company – and if the bridge company were to default with the value of its collateral insufficient to cover the value of the loan, the FDIC would force other banks to cover the shortfall to the Treasury.

With this backstop, as well as the potential for insured depository institutions to access the Federal Reserve’s discount window, supporters of the SPE framework believe short-term creditors will be less inclined to cut and run.

“Initially, there is likely to be a need for liquidity support because of the potential uncertainty surrounding the firm, but this uncertainty will quickly peter out. This has frequently been observed with bridge banks under the FDIC receivership process. Once customers and counterparties figure out they’re facing an entity that is well capitalised and has a solid liquidity backstop, things settle down pretty quickly,” says New York-based Jim Wigand, former director of the office of complex financial institutions at the FDIC, and one of the key architects of the SPE mechanism.

Not everyone agrees, though. For one thing, creditors might be deterred by the fact the US Treasury liquidity is backed by the bridge company’s assets, meaning they would be subordinate to the OLF. For another, there are questions over what would happen in the event the US Treasury is constrained in its ability to provide funds to the OLF, perhaps because it has hit the debt ceiling – an unthinkable outcome even a few years back, but now a slim possibility given the political stalemate in the US.

In that unlikely event, the central bank could probably invoke section 13(3) of the Federal Reserve Act if new conditions imposed by the Dodd-Frank Act are satisfied, says Randy Guynn, partner and head of the financial institutions group at law firm Davis Polk & Wardwell in New York. This clause has historically allowed the Fed to authorise any Federal Reserve bank to extend credit to an individual, partnership or corporation in unusual and exigent circumstances. However, the rule was amended by Dodd-Frank, and the emergency lending authority can now only be extended to participants in a programme or facility with broad-based eligibility. The Fed will also have to seek approval of the Treasury secretary.

These may be far-fetched concerns, but there are other, more pressing worries – for instance, whether US regulators would be happy to provide funding to a new bridge company when some of that liquidity might be passed down to cash-strapped foreign subsidiaries.

“Are US regulators managing the OLF going to be prepared to put money into the bridge so it can downstream cash to fund a run in a foreign subsidiary? That is one of the big unanswered questions. Relevant worldwide regulators need to work out beforehand among themselves whose responsibility it will be to fund the regulated subsidiaries in the various jurisdictions. If there is any confusion on the day of reckoning, and any delay in liquidity being provided, a full-scale run could ensue,” says Millstein & Co’s Millstein.

In fact, the whole question of how to deal with foreign subsidiaries is uncertain. For the SPE mechanism to work properly, foreign regulators must be sure any losses at a local subsidiary would be dealt with at the parent level, with much-needed capital passed back to the foreign entity. Without that level of comfort, foreign regulators could choose to seize the assets of the subsidiary and try to resolve the local entity themselves, undermining the whole SPE concept.

There are a number of possible ways capital can flow down to the subsidiaries, including parent guarantees and support-type arrangements. But the method that seems to be gaining most traction is based on an intra-company bail-out, where the holding company would be forced to purchase intra-company bail-inable debt from the individual subsidiaries. At the point the subsidiary experiences losses, a trigger level is hit and the debt is converted to equity. In this way, the losses are pushed to the parent company and the subsidiary is recapitalised in one swoop.

This is the preferred mechanism for foreign regulators, as the trigger for conversion will be in their hands. But an agreement needs to be reached on where the triggers are set, and this is easier said than done.

“Host jurisdiction regulators holding the debt triggers is the best way forward, as it gives them security they will be able to preside over the recapitalisation of the subsidiary. But this does require a lot of regulatory co-operation, and as the host and home authorities discuss the terms of the triggers, they will discover whether they trust each other or not,” says one former European regulator.

It may be the favoured option for some regulators, but many banks are wary of the idea, which they fear will be hugely sub-optimal from a capital perspective. “We accept there may have to be some kind of pre-positioning requirement to satisfy the concerns of the host country regulator. But there needs to be a middle ground. The trick is finding a happy medium where foreign regulators are comfortable, but we are not sacrificing capital efficiency,” says the general counsel at one US bank.

Another key aspect of the rules yet to be determined is the actual amount of loss-absorbing debt banking groups will have to hold. The entire SPE strategy is predicated on the fact there is enough debt to recapitalise loss-making subsidiaries, and the Federal Reserve and the FDIC will require bank holding companies to issue and maintain a minimum.

But what will that level be? It must be enough to replace the equity that could be lost, says ex-FDIC’s Wigand. “If you assume the worst case, where equity would be wiped out, then you would need at least as much debt as there is equity to be able to fully recapitalise the firm. It would be prudent to also factor into the loss-absorbing layer a marginal amount to cover losses that would exceed equity capital,” he says.

Others would set it even higher. “If it was up to me, I would first ensure there would be, at a minimum, double the Tier I capital amount and then I’d add on a buffer of up to 5 percentage points extra. So if the Tier I requirement was 10%, my minimum would be 15%,” says the former European regulator.

Assuming US regulators ask their big banks to hold 20% in total loss-absorbing debt – roughly double the 10.5% total minimum capital level required under Basel III – only three of the big six US banks would be required to issue new debt, according to research by Wells Fargo and based on January 2013 figures. Those are Bank of America Merrill Lynch, JP Morgan and Wells Fargo itself (see figure 2). But while the first two could hit the minimum by issuing an extra 16% and 17% of long-term debt, respectively, Wells Fargo would need to raise an extra 133% – nearly $81 billion in additional issuance.

This has prompted some to suggest the minimum should vary by business model. “One way regulators could go about doing this is to look to the Sifi buffer tiering and use that as a guide to determining minimum debt amounts, which would help adjust for the different business models. Those that have a higher Sifi buffer could be required to hold extra debt, while those with a small buffer could be required to hold less debt,” says James Strecker, a bank analyst at Wells Fargo in Charlotte, North Carolina. According to the most recent Sifi allocations by the Financial Stability Board in November 2013, JP Morgan would be subject to a 2.5% Sifi surcharge, Bank of America Merrill Lynch would have to hold 1.5% and Wells Fargo would be subject to a 1% charge.

Another issue regulators need to resolve is the provisions that exist in certain financial contracts. Over-the-counter derivatives documentation, for instance, contains early termination rights that allow a firm to close out a trade following the bankruptcy of a counterparty. The Dodd-Frank Act prevents these clauses from being exercised via a short-term suspension following the commencement of insolvency or resolution proceedings against a counterparty, essentially giving resolution authorities time to transfer derivatives contracts to a third party or bridging entity where necessary.

But this only applies to contracts governed by US law. As a consequence, regulators are concerned about the implications in a cross-border context – prompting a letter from four central bank heads to the International Swaps and Derivatives Association in November, requesting action to be taken. Signed by Bank of England governor Mark Carney, president of the Bundesanstalt für Finanzdienstleistungsaufsicht, Elke König, chairman of the FDIC, Martin Gruenberg and chief executive of the Swiss Financial Market Supervisory Authority, Patrick Raaflaub, the letter calls for the association to consider potential changes to the documentation to limit the exercise of termination rights. The other alternative is for the stays to be enshrined in law as they have in the US – something that is currently being contemplated in Europe.

However, if a jurisdiction fails to enact legislation enforcing stays, and private counterparties refuse to alter swaps documentation because of fiduciary duties, the former European regulator suggests regulators will be forced to require banks to hold extra capital, providing an incentive to push changes through.

While some participants may be worried about curtailing their early termination rights, bond investors are also concerned about whether the SPE mechanism could distort perceptions of bank counterparty credit risk.  

“One of the major consequences of SPE is that the operating subsidiaries are more often than not going to survive if the firm fails. As a result, counterparties trading with operating subsidiaries will start paying less attention to counterparty credit risk and will be less likely to withdraw liquidity, switch prime brokerage or novate swaps trades away from the bank. This means the signals bond investors have traditionally relied on for pricing of bonds and used to trigger spread widening will have decayed significantly,” says one head of fixed income at a major bond investor in New York.

Other investors believe that even though SPE in theory makes operating subsidiaries less risky, counterparties won’t pay too much attention to that fact. “I don’t think prime brokerage clients, derivatives counterparties and short-term creditors will distinguish between subsidiaries and parents, even with the resolution mechanism. The cost of being wrong is too great and the benefit of being right is too small. There will still be a signal to the bond market even if it is not as pronounced,” says one head of trading at a US asset manager in New York.

 

The end of the TBTF funding subsidy

Since taxpayers bailed out the banking industry in 2008, it has been argued that large banks have benefited from an explicit funding subsidy – in other words, they have been able to pay less to raise debt, as investors believed the government will always rescue a failing institution. If the new single point of entry resolution strategy is credible, then that subsidy should in theory be eliminated or at least get smaller. And there is evidence that is happening.

Since the government-sponsored bail-outs of the US banking system in 2008, rating agencies have included an uplift in their bank holding company ratings that reflect government backing. But on November 14, Moody’s Investors Service took the decision to remove US government support from the ratings of bank holding company debt, citing the emergence of stronger regulatory resolution tools. The rating agency downgraded the holding company long-term senior debt of Bank of New York Mellon, Goldman Sachs, JP Morgan and Morgan Stanley. At the same time, the firm upgraded the short-term ratings of the bank operating subsidiaries of Bank of America and Citi.

The spread differentials between holding company debt and operating company debt of large US banks have also started to change. According to data from Credit Suisse, the historical option-adjusted spread differential between five-year holding company debt and the legally subordinated operating company bonds of Bank of America, JP Morgan and Wells Fargo started to shift in March last year. Prior to March, holding company debt traded at up to 30 basis points tighter than operating company debt. This subsequently reversed and operating company debt started to trade flat or up to 20bp tighter than the holding company bonds (see figure 1).

According to the same analysis, the premium that existed between large and small banks in the US has also receded. After the crisis, the big six US banks traded at a premium to regional banks due to the presumption they were too big to fail, sometimes trading at a premium of over 300bp. But that premium has since been wiped out and the basis has reversed, with regional banks trading flat or through the big six.

Not all signals are behaving as expected, though. Holding company bonds of the major US banks are trading at their tightest all year, as are five-year credit default swap spreads, which seems to fly in the face of an expected widening of spreads as a result of new resolution tools. But bank analysts say this is due to surplus demand, and investors are starting to factor in the impact of regulatory movement on bank resolution.

“It is difficult to separate the wheat from the chaff when it comes to the impact resolution tools have had on spreads so far given the overwhelming demand for spread products and the prominent role financials play. But investors are fully cognisant and attuned to the implications. As demand for credit starts to mean revert, the impact should become more visible,” says Robert Smalley, global financials credit desk analyst at UBS in New York.

 

Title II decision-makers

The decision to resolve a systemically important financial institution (Sifi) under Title II of the Dodd-Frank Act is a multi-step process. First, two-thirds of both the Federal Reserve Board and the board of directors of the Federal Deposit Insurance Corporation (FDIC) must make recommendations to the US Treasury secretary determining that the company is in default or in danger of default, and detailing what effect the collapse would have on US financial stability and the potential adverse effects resulting from proceeding under the Bankruptcy Code.

The Treasury secretary would then, in consultation with the president, determine whether the Sifi is in default or danger of default and whether the failure and its resolution under bankruptcy would have a serious adverse effect on US financial stability. If all conditions are met, then a 24-hour judicial review process is initiated, if applicable.

At the end of this period, the FDIC would be appointed as receiver, the bridge financial company would be chartered and a new board of directors and chief executive would be appointed.

 

Title II: securities-for-claims exchange

If a bank is placed into Title II receivership, a valuation is performed and the company’s assets are then written down and losses apportioned to the claims of the shareholders and debt holders that have been left in the receivership, as per the order of priority.

According to an example from the Federal Deposit Insurance Corporation, ABC Bank has $15 billion in equity, $128 billion in subordinated debt and $120 billion in unsecured debt. If the bank is placed in receivership and has estimated losses of between $140 billion and $155 billion, then shareholders and subordinated debt holders lose their entire respective claims of $128 billion and $15 billion. Additionally, unsecured debt holders lose $12 billion of their $120 billion in claims against the receivership.

To exit the bridge financial company, NewCo must meet or exceed all regulatory capital requirements. To do this, the unsecured creditors are given $100 billion in equity, $3 billion in subordinated debt and $5 billion in senior unsecured debt of NewCo. Also, call options, warrants or other contingent claims are issued to compensate the unsecured debt holders for their remaining claims ($12 billion). The former subordinated debt holders and equity holders of ABC Bank are also issued call options, warrants or other contingent value rights for their claims, which would not have any value until the unsecured claimants had been paid in full.