• by Randall D. Guynn, Partner and Head of the Financial Institutions Group, Davis Polk & Wardwell LLP, and Reena Agrawal Sahni, Counsel, Financial Institutions Group, Davis Polk & Wardwell LLP
Parties on all sides of the “too-big-to-fail” debate agree that facing another financial crisis without an effective means of resolving systemically important banking groups (“SIBs”) would be unacceptable. But there has been much deliberation about whether the mechanisms put in place since the crisis are up to the task. One critical factor in maintaining financial stability during a SIB resolution is making sure the relevant authority communicated its intended path with clarity and certainty.
Here in the United States, the Dodd-Frank Act gives the FDIC the power, under Title II, to effect a resolution. The FDIC, as receiver, would have the tools necessary for an orderly resolution of a failed SIB, but in order for this “tool kit” to be effective, there must be sufficient information and transparency—in advance of resolution—about how the tools will be used. To that end, the agency has been working toward fleshing out a “single-point-of-entry” strategy for how it would recapitalize a U.S. G-SIB.
The FDIC may also invoke Title II to resolve a non-bank financial company—only if it would “avoid or mitigate” the adverse effects of liquidating or reorganizing the company under the Bankruptcy Code. Again, the FDIC’s ability to achieve this outcome depends on clearly articulating why resolution under Title II would be the better choice for maintaining financial stability. If creditors throughout the system fear that they could be worse off under Title II, they might run for the exits even earlier at the first sign of trouble at a major financial institution. Such an accelerated run throughout the system would exacerbate, rather than avoid or mitigate, whatever serious adverse effects a bankruptcy proceeding might have on financial stability.
In addition to these heightened public risks, access by any firm (financial services or otherwise) to debt capital and funding markets during financial distress hinges upon the ability of credit providers to estimate the probability of that firm’s default and the loss of the given default; only then is a lender able to correctly price risk exposure. The ability to reliably predict what would happen when a borrower reaches the point of nonviability is integral to that analysis.
Without an identified preferred path, market participants will have no recourse but to look to actions taken during crisis events in the past as a basis for guessing what might happen next. If the FDIC identifies and commits itself to a clear path now—in “peacetime” —such action will allow market participants to make their risk assessments on an informed basis today, rather than leave them guessing at the height of a financial panic when they are likely to be extremely risk averse and jittery.
To its credit, the FDIC’s recent SPOE Notice goes a long way towards articulating how the FDIC would use its authority under Title II. An express statement that SPOE is the preferred path under Title II would further reinforce the credibility of the FDIC’s determination to impose losses on the shareholders and creditors of the failed parent of a U.S. G-SIB. Such a statement would also give investors, counterparties, rating agencies, foreign supervisors, and the public increased confidence that the FDIC will use this authority in a manner that maximizes value and maintains financial stability.
SPOE Emerges and Gains Momentum
Presentations, statements, and exercises by regulators around the world have indicated a growing consensus around the desirability of using the SPOE approach to resolve G-SIBs—a consensus that could, ideally, lead the FDIC to declare that SPOE is the preferred method for resolving a U.S. G-SIB under Title II.
SPOE grew out of proposals to resolve financial companies using a technique called “bail-in” as a recovery tool. The idea that bail-in could also be used as a resolution tool, instead of just a recovery tool, was first suggested during the question and answer period after a debate organized by the Institute of International Finance and hosted by the Federal Reserve Bank of New York.
The “bail-in within resolution” idea germinated into a joint comment letter from the Securities Industry and Financial Markets Association and National Unrecovered Financial Services Association that urged the FDIC to develop a recapitalization (bail-in) within resolution strategy for resolving firms under Title II of Dodd-Frank. The FDIC subsequently described that letter as “an example of the value generated by constructive dialogue between the private financial markets and the federal government on topics such as this one.”
The Financial Stability Board subsequently endorsed bail-in within resolution as a key attribute of an effective resolution regime for financial institutions. The FDIC developed the SPOE strategy in the process of adapting the recapitalization (bail-in) within resolution model to the U.S. bank holding company. James Wigand, director of the FDIC’s Office of Complex Financial Institutions first described it publicly in January 2012. Gregory Baer of JPMorgan Chase subsequently illustrated the strategy using an actual U.S. G-SIB’s balance sheet.
The Bank of England later published a joint paper with the FDIC endorsing the SPOE strategy. Paul Tucker, then deputy governor for financial stability at the Bank of England and chairman of the Resolution Steering Committee of the Financial Stability Board, co-authored an op-ed in the Financial Times together with Martin Gruenberg, then FDIC chairman, on the promise of the SPOE strategy in providing a viable solution to the too-big-to-fail problem.
On May 15, 2013, FDIC Chairman Gruenberg announced that the FDIC, the Bank of England, and the U.K.’s Financial Services Authority had agreed that the SPOE recapitalization strategy could be used to resolve SIFIs in both countries. On October 13, 2013, Gruenberg noted that the U.K., Germany, and Switzerland had endorsed SPOE as the preferred strategy for resolving global financial institutions, and that progress toward broader endorsement was being made in Europe, China, Japan, and elsewhere. In the E.U., the Bank Recovery and Resolution Directive includes the power to bail-in debt through a SPOE resolution strategy.
Meanwhile, regulator discussion and endorsements continued to multiply in the United States:
- On June 17, 2013, Thomas C. Baxter, executive vice president and general counsel of the Federal Reserve Bank of New York, called SPOE a “visionary breakthrough idea.”
- In Congressional Testimony on July 11, 2013, Chairman Gruenberg described how SPOE would be used to resolve a SIFI, and indicated that the FDIC expected to release a policy statement providing further clarity on the SPOE resolution process by the end of 2013.
- On October 18, 2013, Governor Daniel Tarullo of the Federal Reserve Board said that the SPOE strategy “offers the best potential for the orderly resolution of a systemic financial firm.”
- The same day, William Dudley, the president of the Federal Reserve Bank of New York, offered his endorsement of SPOE as “the best plan for implementing Title II.”
In short, within two years of its first mention, SPOE has achieved the status as the leading strategy for solving the too-big-to-fail problem for G-SIBs with centralized structures—provided these banks have a sufficient amount of combined capital, long-term unsecured debt, and other loss-absorbing resources at the top-tier parent.
SPOE Notice: The Most Details to Date
On December 10, 2013 as a culmination of this series of developments and endorsements, the FDIC released its SPOE Notice. The notice summarizes the conditions for the use of the strategy, describes the process, and provides greater detail on the issue than any prior publication from the agency.
The notice emphasizes that bankruptcy remains the first option for a U.S. G-SIB encountering severe financial distress and that a Title II resolution would only occur if resolution under the Bankruptcy Code could not be implemented without serious adverse effects on financial stability. Should the Treasury Secretary in consultation with the President make that determination, the Treasury Secretary would place the U.S. G-SIB’s top-tier parent into an FDIC receivership under Title II’s Orderly Liquidation Authority. The FDIC then would charter a new bridge financial company and appoint a new board of directors and CEO. Most employees would stay, but the FDIC would remove members of management responsible for the failure.
All of the top-tier parent’s assets, including its interests in the group’s operating subsidiaries, would transfer to the bridge company. Certain claims would likely also transfer to the bridge, including fully secured claims and obligations of vendors providing essential services. Shareholder equity, long-term unsecured debt, including subordinated debt and a substantial portion of other unsecured liabilities of the top-tier parent, would remain in the receivership. The bridge company would use certain assets to recapitalize the operating subsidiaries so that they can continue business.
After these transfers, the FDIC expects the bridge company and its subsidiaries to be in a position to borrow from the private markets. If private funding is unavailable, the FDIC may provide temporary secured advances or guarantees from the Orderly Liquidation Fund until private funding can be accessed. The notice emphasizes that OLF funding would only be used for a brief transitional period, in limited amounts and with the specific objective of discontinuing use as soon as possible. Any OLF advances would be fully secured. In the event that assets of the bridge company and subsidiaries are insufficient to repay the FDIC for OLF funding, the FDIC would be able to impose risk-based assessments on all eligible financial companies, ensuring that FDIC obligations are always repaid without taxpayer funds.
The notice indicates that the statutory priority of claims would be followed. The notice also states that the FDIC would generally treat creditors within the same class and priority in a similar manner. Additionally, all creditors must receive at least what they would have if the company been liquidated under a hypothetical liquidation under Chapter 7 of the Bankruptcy Code or other applicable insolvency regime.
The FDIC’s SPOE strategy provides for the payment of creditors’ claims through the issuance of new debt, equity, and possibly contingent securities, such as warrants or options by the bridge company, when the bridge is converted into a new company. These securities in the new company would be distributed to the claimants left behind in the top-tier parent’s receivership in satisfaction of their claims. The notice expresses the FDIC’s goal for the bridge company to be ready to execute this securities-for-claims exchange within six to nine months.
How far does the notice go in terms of in terms of committing the FDIC to an SPOE strategy? It says that the FDIC has chosen to “focus” on the SPOE strategy, and notes that the SPOE strategy generally achieves the goals of Title II, but it stops short of declaring the SPOE strategy to be a preferred path for resolving a U.S. G-SIB under Title II.
The Paramount Need for Certainty
The technical correctness of the SPOE strategy, although a necessary requirement, is not sufficient to ensure its success. Foreign supervisors and the market, particularly counterparties and short-term creditors, must have confidence that the FDIC will execute this strategy. If the confidence of these stakeholders wavers, they may run or ring-fence at the first sign of trouble at a large financial institution, for fear of an alternative outcome.
By publicly articulating and committing to a “preferred path” for U.S. G-SIBs, the FDIC can help to change the market’s expectations and curb otherwise likely panic behavior. Committing to a preferred path will:
- Allow firms to equip adequately and capitalize properly.
- Allow counterparties and creditors to price their risk adequately in light of their likely treatment in resolution.
- Allow regulators to target and focus on the information that would be necessary in a financial market meltdown to execute on that likely strategy.
Recovery and resolution plans can be produced for the most likely resolution path, rather than for some hypothetical resolution that is not likely to occur under a set of rules that is not likely to be applied.
To buttress a statement that the SPOE is a true preferred path, the FDIC should continue to issue rules and regulations that convince the market that Title II will be exercised in a transparent and consistent manner that strikes the right balance of ensuring financial stability, maximizing value, minimizing losses, preserving equal treatment among similarly situated creditors, and promoting market discipline. Creditors must have confidence that they would be better off, never be worse off, if Title II is invoked during a financial panic. Only then will Title II have a stabilizing impact on the market during a financial panic.
The expectations and planning for SPOE will not be easily upended upon a change in FDIC board membership, or inevitable turnover in staff, if the agency firmly establishes this strategy through rules and regulations that have been presented with notice and opportunity for comment. Such action now would help regulators withstand constitutional and other challenges when it comes time to implement a resolution plan.
Moreover, laying out a preferred path in advance will also help foster international cooperation and coordination. Though the SPOE model largely addresses the most difficult cross-border impediments by keeping bank and other operating subsidiaries out of insolvency or other resolution proceedings, it still requires understanding and agreement among the home and host country regulators. Clarity about how the FDIC will exercise its statutory discretion will facilitate cooperation among regulators and preempt any early action by host country regulators that could undermine an implementation of the resolution strategy.
The release of the SPOE Notice was a step in the right direction, but stronger statements from the FDIC would create greater market confidence. •