Too-big-to-fail problem solved, claim leading industry figures

FDIC's single-point-of-entry method applauded but concerns still linger

US regulators have solved the too-big-to-fail problem, and the country could cope with the failure of a systemically important financial institution (Sifi) now without putting taxpayer money at risk, according to several leading industry figures.

Their comments follow a consultation document issued by the Federal Deposit Insurance Corporation (FDIC) at the end of last year, which details how the resolution process introduced under Title II of the Dodd-Frank Act would likely work in practice.

"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.

Under the FDIC plan, published on December 10, resolution authorities would take a single-point-of-entry (SPE) approach, meaning they would deal with the problem at the holding company level, rather than trying to resolve individual troubled subsidiaries of the group. Simply put, the regulators would rapidly move to transfer the bank's assets to a new bridge company, and then write down debt and equity issued by the holding company to cover losses and recapitalise the new entity. Throughout this process, the subsidiaries would continue to operate - hopefully with market participants comforted by the fact the new entity is quickly put on a sound footing.

We have solved the biggest problem of the 2008 crisis, in the biggest market in the world

That sounds like a sensible – and workable – solution to many. 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 Sifis in the US, shortly before stepping down as deputy governor at the Bank of England. On December 5, US Treasury secretary Jack Lew agreed regulators will meet the test of ending too-big-to-fail.

But there are plenty of sceptics. 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," he says.

"How deep that impact will be will depend 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," Miller adds.

Others raise a different objection, but reach the same conclusion. "In designing the resolution mechanism, regulators have made the assumption that 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.

Some of the technical detail of the FDIC's plan still has to be ironed out, but critics point to the interaction with foreign regulators as being a particular area of concern. 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 by US authorities, with much-needed capital passed back to the foreign entity. Without that level of comfort, foreign regulators could choose to seize assets of the subsidiary and try to the resolve the local entity themselves, undermining the whole SPE concept.

On the flip side of the coin, US authorities may be reluctant to extent temporary liquidity support – conducted through an emergency US Treasury collateralised facility called the Orderly Liquidation Fund (OLF) – if some of that capital is passed to foreign entities.

"Are US regulators managing the OLF going to be prepared to put money to the bridge so it can downstream cash to fund a run on 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.