WASHINGTON — The Federal Deposit Insurance Corp. is not waiting for regulatory reform's enactment to develop plans for a new resolution system.
Under the final reform bill, which the House approved last week and is expected to pass the Senate soon, the FDIC would for the first time be required to unwind large, systemically important banks and nonbanks to prevent the type of disorder caused by Lehman Brothers' bankruptcy in 2008.
Even though another failure of a systemically vital firm is a distant possibility in the short term, the agency is required to issue several rules to ensure a new structure is up and running soon.
"This is not the kind of authority you want to wait until the last minute to exercise," said V. Gerard Comizio, a partner at Paul, Hastings, Janofsky & Walker.
Key early tasks for the FDIC include providing market clarity for creditors on what they would receive, if anything, in a failure of a systemically important firm; designating certain FDIC officials to focus on the new resolution powers; and researching the companies the agency may have to unwind. The FDIC will also have to address issues associated with having two different resolution funds: one for banks and another for nonbanks.
Michael Krimminger, the deputy to the FDIC chairman for policy, said the agency has done "preliminary planning" in order not to be caught flat-footed once the implementation schedule begins. He said the sooner the market has clarity about what happens to a large firm when it fails, the better.
"We think it's imperative to move quickly, simply because we can't be in a situation in the future like we were in the fall of 2008. Then, things had to be done on a much more ad hoc basis than they ever should be, because no one had the statutory authority to resolve the largest nonbank firms," Krimminger said.
The legislation, which is likely to be signed by the president this month, would require the establishment of the orderly resolution structure immediately after enactment.
"One of the first things they would need to do is develop an internal organization that is ready to deal with the new mandate," said Satish Kini, a partner at Debevoise & Plimpton LLP.
Observers said the new regulations would have to lay out specifically how the agency plans to treat everything from financial contracts between counterparties, to customer accounts, to the transfer of assets to an acquirer.
"Unlike the bank receivership process, which is tried and true and there is a long history out there of how to handle things, this is completely new," said Kevin Stein, a managing director in FBR Capital Markets and a former associate director in the FDIC's resolutions division. "The legislation is like the blueprint. The FDIC would have to build a set of construction documents. From the construction documents, you then have to hire contractors, and then they have to build the foundation."
The legislation requires the agency to try to harmonize the rules with the current insolvency procedures in the bankruptcy code.
In addition, the bill would grant the agency authority either to lead or participate in rule-writing with other regulators on more specific issues, including how receiverships would be terminated, joint rules with the Securities and Exchange Commission related to the liquidation of broker-dealers and regulations on how the agency could use funds to run a receivership.
The bill would allow the FDIC to borrow funds from the Treasury and pay them back through recovery sales and assessments on other systemically important firms. A separate rulemaking would establish the new assessment system.
Other parts of the bill require additional regulations, including a joint rulemaking with the Federal Reserve Board on standards for large firms to lay out their own resolution plan, or so-called living will.
How the agency will establish rules to pay off creditors is likely to be a source of significant debate, observers said.
Stein said there is currently no rule book for how a receiver would deal with a failed nonbank's counterparties, and while transferring the core of a bank to a buyer is the agency's bread and butter, assisted transactions for nonbanks are another story.
"There is a long history of how the FDIC deals with these items in a bank receivership, but there's really no precedent and no model at the FDIC for the nonbank context," Stein said. "They're starting with the existing resolution process" for banks "and the bankruptcy code. It could take them a long time to put the framework in place."
He added that while bank receiverships follow a rigid hierarchy of which liabilities are covered, it is unclear whether the FDIC would have a similar order for nonbanks. "The issue of the priority of claims has to be spelled out: can they handle assets and liabilities individually, can they cherry pick what they sell and what they hold back, and in what priority do they do it?" Stein said.
But the agency does have at least one advantage since nonbank receiverships would not entail any insured depositors.
Krimminger said that could give the agency some breathing room since there would be no statutory requirement that the agency provide relief beyond what it gets from resources inside the failed institution.
"Since you don't have any guaranteed creditors — you don't have the $250,000 to depositors — you're much more likely to be able to recover all of the administrative expenses from selling the assets," he said.
Others said the mix of assets and liabilities the agency would have to sort through is comparable to what it finds in failed banks.
"On the liabilities side you do have points of considerable distinction, where banks are mainly deposit-taking institutions and [companies] like Goldman Sachs would have nothing in the way of deposits. It's funded with a variety of different borrowing sources," said William Longbrake, a former vice chairman of Washington Mutual and FDIC chief financial officer, who is now an executive-in-residence at the University of Maryland.
"But even there, the FDIC does deal with those sources: subordinated debt and other debt instruments in banks, and asset-backed securities that were issued by the failed institution."
Also on the agenda for implementing the new system is labeling exactly which institutions could fall into the FDIC's hands.
"The first step has got to be: What's the universe? Who's potentially a ward of this new authority?" said William Isaac, a former FDIC chairman and now the chairman of Fifth Third Bancorp, who spoke for himself and not the bank. "I would be studying their financials and trying to figure out: What would be the challenge of taking one over?"
Observers said the process of designating firms as subject to the resolution authority would likely be intertwined with steps led by the Fed and new Financial Stability Oversight Council to identify companies covered by new systemic-risk regulations. Healthy systemically vital firms would have to submit to regulators a detailed plan of how they would wind down in a failure scenario.
"The FDIC will have a seat on the council, which may be helpful," Kini said. "In addition, they will be involved in the process of crafting living wills, which will serve as a road map for the FDIC if they ever have to use the new authority under the statutory regime."
But some observers said there is a risk in too much pre-planning. Comizio said that, while it is helpful to gather information about firms while they are healthy, the FDIC would need to be careful not to pigeonhole itself into one type of resolution plan.
"One of their main challenges is walking through the dance steps of resolution for the major types of nonbank financial institutions," he said. "The FDIC doesn't need to go into grim detail."
The agency "would be doing itself a disservice to lock itself into any identified approaches right now," Comizio said.
"They're going to be given the authority, and then I think they need to give themselves enough flexibility under the law to basically proactively respond to a situation where they're going to be called upon to exercise the authority."
Many experts agreed the FDIC has likely already assigned staff to begin preparing proposals.
"My guess is they've already had a task force internally working on this," Longbrake said. "They haven't been sitting on their hands waiting for this bill to pass. … They will have the ability once the bill is signed to make some preliminary statements."
Yet the total permanent amount of staff required to run the new resolution operation would likely be small, he added, since takeovers of systemically important nonbanks would be uncommon.
"Generally, the way the FDIC runs the resolution authority is with a fairly small dedicated staff which they can expand or contract, depending on the number of actual resolutions they have to handle," Longbrake said.
"I would expect a fairly small number of additional people. … You don't have anything that's going to fall in their laps. You can still reach back into the agency's resources that it already has in the legal area and the liquidation area and the resolutions area, and draw on that expertise that already exists."
But the agency also faces the task of accounting for the resources it spends on running the nonbank unit, which are separate from the reserves held in the Deposit Insurance Fund used for resolving banks.
Under the bill, the agency would initially borrow funds from the Treasury and repay them from a separate account funded by assessments from the largest financial firms.
Krimminger said there is a precedent for the agency utilizing different pots of resources. The FDIC faced similar split accounting requirements when it resolved banks and thrifts separately out of the Bank Insurance Fund and the Savings Association Insurance Fund. (Congress merged the two funds under the 2006 deposit insurance reform law.)
Even today, resolution staffers working on a specific receivership must account for expenses and compensation from the funds available in that receivership.
"When our resolution staffs work on particular failures, they charge their time to those specific receiverships," Krimminger said. "We are very scrupulous now about making sure that our work is charged to the right receivership. … In the past, if you were working on something that was SAIF-oriented, you would charge it to the SAIF. If you were working on something for the Bank Insurance Fund, you charged it to the Bank Insurance Fund."
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