• by Gregory Baer Managing Director and General Counsel, JPMorgan Chase
In the wake of the financial crisis, U.S. legislators and regulators have initiated dramatic changes to how finance is regulated. They have also changed fundamentally the way that large financial companies will be resolved. The former effort focuses on forcing financial holding companies to take less risk and hold more capital and liquidity against the risks they do take; the latter effort focuses on ensuring that, no financial company will deemed “too big to fail” should it face insolvency. To date, public debate about financial regulation generally has been divorced from debate about resolution. This conceptual split is mirrored by a division of labor among regulators or practitioners working on these issues. Further hindering the discussion is the fact that resolution planning generally has been deemed confidential supervisory information, with its implications for regulation consequently largely unobserved.
Recent and revolutionary developments in resolution strategies for large banks—in particular, the FDIC’s single-point-of-entry (“SPOE”) resolution strategy under Title II of the Dodd-Frank Act (“Dodd-Frank”)—in fact have significant implications for how policymakers should view policies for large bank regulation. Conversely, ongoing regulatory changes should inform the debate about resolution strategy.
The purpose of this paper is to identify tensions between current U.S. paths for regulation and resolution and suggest a framework for gauging at what point collective changes in regulation and resolution ensure sufficient stability. This effort is significant because when a given regulatory or resolution policy is viewed in isolation, policymakers will always tend to err on the side of more stringent rules for U.S. banks—tellingly now referred to as “gold plating”—as an unalloyed good, even when such rules may be superfluous or counterproductive when viewed as part of the overall regulatory and resolution regime.
Background: Title II, Single Point of Entry, and Revolutionary Change
Title II of Dodd-Frank assigns the role of receiver for large financial holding companies and designated non-financial holding companies to the FDIC. This was a revolutionary change for the FDIC, whose primary and eponymous purpose had been the insurance of federally insured deposits and resolution of those banks, and only those banks, that offered them. In retrospect, the FDIC’s experience in resolution and subsequent success in implementing Title II make its choice look wise. One downside, however, is a blurring of the distinction between holding company and bank resolution, which is in fact now quite pronounced.
The basics of the SPOE strategy are set forth in the FDIC’s draft notice, Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy:
To implement the SPOE strategy the FDIC would be appointed receiver only of the top-tier U.S. holding company, and subsidiaries would remain open and continue operations…., allowing them to continue critical operations for the financial system and avoid the disruption that would otherwise accompany their closings, thus minimizing disruptions to the financial system and the risk of spillover effects to counterparties.
A recapitalization at the holding company level is a departure from traditional bank resolutions. Traditionally, the FDIC has resolved banks through purchase and assumption transactions. For large financial holding companies, the FDIC under Title II now intends to follow a different path. Losses, wherever in the organization they originate, will be borne by the parent holding company’s equity and debt holders, and any subsidiary will remain open and operating; debt holders at the holding company will be converted to equity holders, with their losses dependent on returns generated from the receivership.
The SPOE strategy thus can be seen as the final step in implementing the source-of-strength doctrine that the Federal Reserve Board has enunciated for decades. As now codified in section 616(d) of Dodd-Frank, that doctrine mandates that a holding company “serve as a source of financial strength for any of subsidiary… that is a depository institution.” The doctrine was originally used as a standard for evaluating applications to form a bank holding company, and was expanded in 1984 to constitute a ground for finding an unsafe or unsound banking practice when a holding company failed to provide capital support to a bank subsidiary. But once a bankruptcy of the parent company occurs, courts generally have not found such an obligation to be an assumable debt—in particular, they have found that a prior order to serve as a source of strength does not constitute a commitment to maintain capital for purposes of section 365(o) of the Bankruptcy Code and a priority under section 507(a)(9), and that in effect the corporate veil between parent and subsidiary remains. As one observer has noted:
It may be the case that the Board does not intend the source-of-strength provisions in its standard cease-and-desist-order or written agreement to constitute a commitment for purposes of section 365(o) or section 507(a)(9) …Such a conclusion would be consistent with the theory that the broad prophylactic benefit that the Board derives from the source-of-strength doctrine is heightened oversight and a more risk-adverse approach to the operation of insured subsidiaries by the management of bank holding companies.
Regardless of why the Board has not chosen to include in its orders a mandate specific enough to trigger assumption under section 365(o), it is quite clear that in the Title II context, the FDIC will act as receiver of the holding company exactly as if such an obligation had been assumed. Importantly, it also intends to support not just insured depository institution subsidiaries, the focus of the Board’s doctrine, but all subsidiaries, bank and non-bank. And the Board is likely to ensure through regulation that sufficient resources exist at the holding company to cash any check that the FDIC could foreseeably write. Furthermore, even in a Title I context, a bankruptcy court could conclude that the recapitalization of operating subsidiaries is in the best interest of creditors; such a recapitalization would not impose a dead weight loss on holding company creditors but rather enhance the value of the subsidiaries in which they have a stake.
Resolution and its Implications for Regulation
As a result of these changes, holding companies are to a greater extent than ever before able and obligated to provide support for their insured depository institution subsidiaries. Meanwhile, all the traditional restrictions preventing insured depository institutions from putting themselves at risk to benefit a non-bank affiliate—most notably, sections 23A and 23B of the Federal Reserve Act—remain intact, with heightened enforcement. Holding companies are also for the first time likely to serve as a source of strength to non-bank subsidiaries, particularly those that are systemically important. As discussed below, however, numerous regulatory initiatives appear to presume the opposite.
Subsidiarization
Nowhere is the tension between regulation and resolution stronger than with respect to the notion of subsidiarization, or ring-fencing. Subsidiarization is not a precisely defined term and could take many forms, from imposing minimal capital requirements to requiring local subsidiaries to be governed and funded as if they were independent entities. The ostensible goal is to ensure protection of host country creditors in the event of a failure of a local subsidiary, on the assumption that host country support will not be available.
The downsides of subsidiarization in its more extreme forms are considerable. Global banks would be unable to allocate resources among their subsidiaries efficiently in good times, and would be unable to shift resources to a troubled subsidiary (perhaps in a troubled country) from a healthy subsidiary in bad times. Upon failure, a home country agency attempting to implement an SPOE strategy would have fewer uncommitted resources at the holding company level with which to recapitalize a failed subsidiary; a host country regulator for a healthy subsidiary would be unlikely to allow the transfer of resources from that subsidiary to a troubled one abroad. Contagion would seem likely to spread, as the decision by one host country to ring-fence the assets of its subsidiary would lead others to do likewise, and quickly. A multiplicity of global resolution proceedings would likely prompt confusion and conflict and thereby exacerbate systemic risk.
One of the greatest benefits of single-point-of-entry resolution is that it should obviate the need for subsidiarization. At least in the form it has taken in the United States, SPOE makes quite clear that equity and senior debt holders at large U.S. financial holding companies will bear loss, and the Federal Reserve Board is expected to require such companies to hold levels of equity and debt sufficient to absorb massive losses. This, in turn, will allow subsidiaries to continue in operation. Such an SPOE regime contrasts with a multiple-point-of-entry (“MPOE”) regime, where there are no holding company resources available for loss absorption, and thus there is no ability for a home country receiver to support a foreign subsidiary. One analogy for the difference would be a regime for fighting fires in a town. The town could fund a fire department that would put out a blaze at any house experiencing trouble (SPOE) or could instead forsake the fire department and require each house to have a sprinkler system (MPOE).
The European Bank Resolution and Recovery Directive notes this distinction. It directs each member state to establish a minimum requirement for eligible liabilities (“MREL”) at each subsidiary, but states that “loss absorbing capacity should be determined entity-by-entity and reflect the resolution strategy which is appropriate to a group as defined in the resolution plan... In particular, the MREL should be required at the appropriate level in the group in order to reflect a multiple point of entry or single point of entry approach....” A different outcome would be akin to the state government allowing a town to build a fire department, and then requiring a sprinkler system for each house anyway.
Of course, with an SPOE regime, every host needs to be confident that the fire department will arrive and put out every fire, regardless of how dangerous the blaze or how demanding the occupants. One could certainly argue that firefighters are in the profession of fighting fires, and are thus unlikely to refuse to do so if they are well equipped and trained. With financial fires, however, that answer may not suffice in some overseas jurisdictions.
One could imagine an arrangement whereby U.S. firms were required to pre-position assets in overseas jurisdictions as a “skin in the game” requirement intended to provide assurance to overseas regulators that support would be forthcoming. Such an amount would need to be substantial enough to provide assurance—effectively, a down payment from which it would be unprofitable for a parent company to walk away—but not so large as to hinder the company from operating efficiently in good times or flexibly in tough times. Too large an amount would also hinder the ability of the FDIC to deploy capital as needed in the event of receivership, as host jurisdictions would be unlikely to give up any trapped capital, even if they held a surplus.
Some have argued that U.S. firms should not avoid subsidiarization abroad because the Federal Reserve Board has imposed it domestically by requiring foreign banking organizations to operate through an intermediate holding company in the United States, subject to the same capital (though not liquidity) standards as U.S. financial holding companies. The Board’s action, however, has two potential justifications that do not appear to apply elsewhere. First, while the United States has adopted an SPOE strategy (and source-of-strength requirement) that will ensure that overseas operations of U.S. banks continue in operation, which the Board will fortify by adopting a minimum loss absorbency requirement at the holding company level, many other nations have not. Thus, U.S. regulators have little assurance that a foreign bank parent would be able to provide support for a U.S. subsidiary. (The Federal Reserve’s intermediate holding company requirement does not apply to branches and agencies of foreign banks, where such support may be presumed). Second, during the financial crisis, the Board was called upon to provide dollar funding to foreign banks through their U.S. subsidiaries and does not wish to repeat that process.
OCC Heightened Expectations
In a similar vein, the OCC’s recently proposed heightened standards for large national banks continue a recent trend towards emphasizing the sanctity of the national bank charter as well as the duties of national bank boards of directors and management to the institution. There is no debate that those actors have a duty to maintain the safety and soundness of the national bank and ensure that it is insulated from problems at any non-bank affiliate, and the heightened expectations are certainly consistent with that notion. That said, the renewed emphasis on legal entity independence comes just as national banks are being given far greater assurance that they will receive parent company support. These changes in regulation (source-of-strength) and resolution (single-point-of-entry) would appear to argue for a greater rather than lesser emphasis on enterprise-wide risk management.
The Tester Amendment
By establishing assets as the base for deposit insurance assessment, the Tester amendment to Dodd-Frank, as interpreted by the FDIC, has broken the link between deposit insurance premiums and risk to the Deposit Insurance Fund (“DIF”). To illustrate, consider that with assets as the assessment base, a large bank could reduce its insured deposits to $1 and likely see no decrease in its premiums.
While such an outcome would seem perverse in any case, it is particularly so given that SPOE and the holding of high loss absorbency at the parent company level have dramatically reduced the risks that large banks pose to the DIF because large banks have the largest percentage of assets funded by liabilities other than insured deposits. Holding company resources will be available to support a troubled insured depository institution to an unprecedented degree, while the insured depository institution will remain insulated from troubles at its affiliates in the way it historically has.
One might argue that while large banks are very unlikely to require payments from the Deposit Insurance Fund and therefore pose little risk to it, they are uniquely eligible to borrow from the Title II Orderly Liquidity Fund (“OLF”), which does not assess ex ante premiums. Thus, excessive payments to the DIF could be seen as substituting for payments to the OLF, as a premium-based SIFI surcharge. There are two problems with this notion. First, large banks and other large financial institutions are already subject to an ex post assessment in the event of any loss to the OLF, and markets presumably will exact an appropriate price on their equity or debt for that contingent liability. Second, policymakers have failed to recognize these assessments as such payments and therefore propose other taxes—literal or pseudo (e.g., a G-SIFI surcharge)—to achieve the same goal.
Push Out
Section 716 of Dodd-Frank mandates “push-out” of certain derivatives activities—most notably, equity, credit and commodity derivatives—from insured banks into their non-bank affiliates. The mandate as a practical matter applies only to the largest banks because smaller banks generally do not engage in derivatives trading, and if they do, it is in interest rate or foreign exchange derivatives, which are exempted by Section 716.
Section 716 appears to reflect a “narrow banking” view of supervision and regulation, whereby the subsidy inherent in the taking of insured deposits should be limited to lending and other traditional banking activities. This view is debatable—for example, an agricultural company may not view a loan as necessarily more worthy of subsidy than a hedge on price variability on its products—but it does have a grounding in the notion that the sovereign should be able to ration its full faith and credit guarantee to those activities it wishes to support. On the other hand, push-out has received considerable criticism for its inconsistency with enterprise-wide risk management.
Resolution policy also has implications for push-out. With holding company resources available in large supply to support any subsidiary of a large bank, it would appear to matter less in which subsidiary an activity is conducted. Furthermore, as discussed above, Dodd-Frank has now codified source-of-strength for bank subsidiaries (the subsidiaries out of which Section 716 is pushing derivatives activities) but not for non-bank subsidiaries (the subsidiaries into which Section 716 is pushing those activities).
Capital Surcharges
U.S. regulators are likely to propose capital surcharges for the largest banks soon. The concept of a SIFI capital surcharge originated with the Financial Stability Board (“FSB”), which defined SIFIs as “financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.” The FSB described such charges as “requirements for banks determined to be globally systemically important to have additional loss absorption capacity tailored to the impact of their default...” Thus, it is odd that the proposed methodology for calculating the surcharge does not consider whether the G-SIFI is subject to a resolution regime that reduces the risk of disorderly failure. In other words, the methodology assumes that all G-SIFIs will fail in exactly the same disorderly manner. While this assumption could have seemed reasonable prior to the financial crisis, it now appears clearly less so given the numerous changes to resolution made in the United States and some other nations.
Other observers have suggested that such a surcharge is necessary to offset a funding advantage that large banks receive by virtue of a financial market assumption that they are “too big to fail”, and thus that holders of their debt are not at risk of default. The evidence of such a funding cost advantage, at least post the implementation of Dodd-Frank, is certainly debatable. In any event, though, policymakers have not identified over whom this funding advantage is alleged to exist given that smaller banks fund themselves predominantly—and in significantly larger proportions than large banks—with deposits insured by the FDIC and thereby guaranteed by the full faith and credit of the United States. It is difficult to see even a subsidized bond issued to the market as conferring an advantage over a deposit or certificate of deposit guaranteed by the government. Finally, if the purpose of the surcharge were to equalize this advantage, with the Board acting as a modern-day Handicapper General, then other costs borne by large banks but not smaller ones would be relevant to the equation; while those costs have proliferated, there has been no attempt to quantify their collective impact and how they affect competitiveness.
Regulation and Its Implications for Resolution
When policymakers speak of large banks being too big or complex to fail, they generally appear to assume that a firm would fail in its current structure and at its current size. However, changes in liquidity profiles at large banks over the past two years, buttressed by regulatory requirements, now invalidate such assumptions. Most significantly, large firms have dramatically expanded their holdings of high-quality liquid assets (“HQLAs”), consisting primarily of Treasury and agency securities. These assets are intended to allow a firm to weather a market and idiosyncratic stress of up to 30 days, allowing the firm to meet cash outflow requirements and to shrink. The regulatory Liquidity Coverage Ratio will establish minimum requirements in this area, and a forthcoming Net Stable Funding Ratio will establish further guidance regarding liquidity out to one year. Resolution planning focuses heavily on funding needs. Furthermore, large banks since the crisis have significantly reduced their reliance on short-term wholesale funding, and regulation is likely to require even further reductions.
As a result of this change in liquidity profile, one is less likely to see large firms quickly succumbing to silent runs in a future crisis, and failing on little notice and with no plan in place. Rather, cash and high quality securities will allow a troubled firm to fund itself via repo, or sell or pledge those securities to meet funding outflows. And relatively healthy firms will be more able to perform a stabilizing function if they are liquid.
There are implications here for Title II but even more so for Title I resolution. In bankruptcy, private debtor-in-possession (“DIP”) financing has traditionally been a relatively low risk and profitable lending opportunity for lenders, given the super-priority afforded to it in the bankruptcy creditor waterfall. However, DIP financing has been less common for financial institution bankruptcies given the speed and disorderly nature of some of these proceedings. Now, higher capital and liquidity requirements mean that the failing firm will have had time to conduct an orderly sell-down of its positions and assets, reducing the amount of any financing required after it enters bankruptcy. Resolution and recovery planning will make that process even more orderly. Thus, the frequently asked rhetorical question “Could a large U.S. bank really be resolved over a weekend?” seems to be based on a false premise: that extraordinarily high liquidity at large U.S. banks will give banks no time to shrink and regulators no time to prepare, leaving all the work to be done over a weekend.
Toward a Unified Theory
In evaluating whether the developing U.S. regulatory regime is appropriate, U.S. regulators might consider three questions: (1) at what level of confidence do they need to conclude that the financial system will not repeat the recent crisis; (2) at what level of confidence are we right now; and (3) do the benefits of measures that would bridge any gap between (1) and (2) exceed other costs—e.g., less liquid capital markets, slower economic growth—that are likely to be produced by such measures?
Behavioral economics strongly suggests that the instinct of policymakers would be to err strongly and irrationally towards avoiding recurrence of the financial crisis at the expense of a long-term gain in economic activity. Thus, to the extent possible, it is important for regulators to rely on objective analysis rather than instinct in weighting the difficult balance here. (Indeed, while it has a conceptual grounding, the term “macroprudential regulation” can at times seem to constitute instinctual regulation.)
A good start would be a test of the resiliency of the current system, considering the impact of both regulation and resolution. Such a test would analyze how the financial system would weather loss rates akin to those seen in the financial crisis, or some multiple of losses projected in the Board’s Comprehensive Capital Analysis and Review (CCAR) stress tests. Would large (or small) banks fail? If large banks failed, would there be sufficient resources to allow them to be recapitalized under either Title I or Title II of Dodd-Frank? Such an exercise would be difficult and its results necessarily imprecise. But its planning would require policymakers to confront in a systematic way the tradeoffs occurring in regulation and resolution every day.
A separate exercise might begin to ask whether current regulatory requirements are imposing costs on credit or capital markets activity, and thereby on economic growth. While proposals for more stringent regulation generally have not considered these costs in a rigorous way, there is of course a limit to how far regulators should go: no one really believes that requiring banks to be 100% equity-funded or barred from non FDIC-insured short-term borrowing would yield an economy in which we wish to live. But there is little debate about where we are on the cost-benefit spectrum when the current regulatory regime is considered as a whole. It would be very beneficial if regulators and policymakers acknowledged as much and thereby gave themselves some latitude in the public mind to avoid “gold plating” every rule. Such an approach did not end well for Midas. •