WASHINGTON — The Federal Deposit Insurance Corp. convened some of the best banking-policy minds on the planet Tuesday to look at how best the agency can use its new powers to unwind a large, systemically important bank.
But even they came away with more questions than answers.
The newly-created panel raised concerns about convincing the market that regulators are serious about shutting down "too big to fail" firms, preventing a resolution from sowing panic in other institutions and utilizing pre-drawn resolution plans when the details of the next crisis are unknown. "I think it was Eisenhower on the Friday after D-Day who was asked about the plan. He said, 'Plans in a crisis are useless. Planning is essential.' I think that is helpful," said H. Rodgin Cohen, a partner at Sullivan and Cromwell LLP and recognized as one of the nation's preeminent banking lawyers.
The inaugural meeting Tuesday of the FDIC Advisory Committee on Systemic Resolution came as the agency implements provisions of the Dodd-Frank Act, which allows the Treasury Department to appoint the FDIC as receiver for failing nonbank firms.
In theory, the new powers will help the government avoid the dilemma it faced in 2008 with firms such as Lehman Brothers, when the choice was between bailing it out or hoping its bankruptcy would not sink the economy.
During the panel meeting, FDIC officials presented findings from a recent agency report on how it would have handled Lehman's demise with the new powers. The agency concluded its resolution could have recovered 97 cents on the dollar for creditors.
But former Federal Reserve Board Chairman Paul Volcker and others pressed the agency further: What if a failure like that of Lehman was just the start, and other institutions were still susceptible to the ripple effect of its failure?
"What would have happened on day two and day three and day four?" Volcker said.
Volcker, formerly the head of President Obama's Economic Recovery Advisory Board, said the FDIC would have to be prepared step in at other institutions.
"Suppose you do your job as described. … Lehman got resolved. Stockholders are out, management is out, the unsecured creditors are losing. … What was at stake here was not Lehman in some sense. It was impressed upon the market that there were $1 trillion of bad credits out there," he said.
Volcker said the problem was that once the market understood the breadth of the problem, "they wanted more collateral from AIG and AIG didn't have any more collateral."
"They didn't want to invest in these other investment banks. They didn't want to invest in Citicorp or anybody else," Volcker said. "If you had this, you would have had to apply it, I suppose, to AIG, to Morgan Stanley and Goldman Sachs and Citibank. That's a hell of a burden you took on there."
Other panelists were more explicit about the potential impact on the agency if it had to resolve multiple institutions in a crisis.
"You would be running the most leveraged hedge fund on the face of the earth," said Michael Bodson, the chief operating officer of the Depository Trust & Clearing Corp.
But FDIC officials countered that, while the agency would act swiftly to find creditor protection in the remaining coffers of the failed firm to mitigate disruptions, Dodd-Frank also enacted other measures to ensure better safeguards against undue risk. They cited a provision in the law allowing broader liquidity support for healthy institutions that could feel the aftershocks of others' problems.
"I hope we never see a cycle like this. The resolution authority by itself can't take care of the lack of lending standards, and the lack of transparency in asset securitizations and all the CDOs," said FDIC Chairman Sheila Bair, but she added other reforms "will provide a more stable base."
"You always have some boneheads that are going to fail. … This will work best when you're dealing with a one-off bonehead."
Several participants highlighted a clear benefit of the resolution system: putting troubled institutions' feet to the fire to find a private-sector solution rather than endure a government seizure.
"The hope is the resolution authority would have given Dick Fuld … a different set of incentives in the spring of 2008," said former Fed Vice Chairman Donald Kohn, referring to Lehman's chief executive before its failure.
But Kohn cautioned that once those incentives became clear, the window for the FDIC to prepare a resolution would get much smaller.
"As firms begin to get into trouble market pressure will be brought to bear appropriately and that will incent the management to try and do something about it," he said. "But when the market foresees the management will not be successful, things are going to go south very, very fast and the liabilities will get very, very short and they will have trouble rolling them over. … This just emphasizes the preparation point. You guys will have to be ready well before the first whiff of trouble."
Volcker agreed the pre-planning process will be crucial. Under Dodd-Frank, regulators can force large firms to draft so-called "living wills" to help guide a hypothetical resolution scenario. If a firm's plan is deemed inadequate, the agencies can make executives go back to the drawing board.
The former central banker said conflicts with firms over the quality of living wills is inevitable, with lawsuits possibly the result. At one point, reflecting the experimentation in the new process, he said, "It would be interesting to try out."
"What do you say? … 'Try harder.' They come back and say, 'We tried hard and there isn't much there. My board agrees with me, … and we're going to take you to court?' What do you do? Give them a cease-and-desist order?" Volcker said.
Bair did not flinch. "Yeah," she said.
Several panel members acknowledged that Dodd-Frank removed previous bailout authority for the government, including the ability to announce a "systemic-risk" exception to least-cost resolutions for individual institutions.
"The statutory provisions pre-Dodd-Frank that permitted 'Too Big to Fail' to exist … they're gone," Cohen said. "We are left with Congress coming to the rescue of a bank."
But some questioned whether that was a good idea, and said congressional requests to aid open institutions are still not out of the question.
"Tying your hands behind your back is nice politically, but it's not the right thing to do," said Anat Admati, George G.C. Parker Professor of Finance and Economics at Stanford University.
The committee also discussed challenges the FDIC would face in a resolution that involved cross-border operations.
Volcker said so far international regulators have not shown they are serious about establishing real resolution measures.
"In principle they all say it's a great idea. In substance, they're not doing a damn thing," he said.
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