The high-risk business model of large financial conglomerates (frequently called “universal banks”) was an important cause of the financial crisis. Universal banks rely on cheap funding from deposits and shadow banking liabilities to finance their speculative activities in the capital markets. By combining deposit-taking and short-term borrowing with underwriting, market making, and trading in securities and derivatives, the universal banking model creates a strong likelihood that serious problems occurring in one sector of the financial industry will spread to other sectors. To prevent such contagion, federal regulators have powerful incentives to bail out universal banks and protect all of their depositors and shadow banking creditors. That is precisely what happened during the financial crisis.

Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 seeks to end bailouts by requiring the Federal Deposit Insurance Corporation (FDIC) to liquidate failed systemically important financial institutions (SIFIs) while imposing losses on their shareholders and creditors. Title II’s liquidation-only mandate threatens the TBTF subsidy for SIFIs and their Wall Street creditors, and it therefore presents a direct challenge to the universal banking model. To meet that challenge, Wall Street developed its “single point of entry” (SPOE) plan for resolving failed SIFIs.

Wall Street’s SPOE plan would ensure future bailouts for SIFIs and their favored creditors while imposing the costs of those bailouts on ordinary investors and taxpayers. Under SPOE, only the parent holding company of a failed SIFI would be placed in receivership, and its operating subsidiaries would be maintained as going concerns. Short-term creditors of the holding company and all creditors of the operating subsidiaries would be fully protected. Protected creditors of the failed SIFI would include uninsured depositors and shadow banking creditors with close connections to Wall Street, such as holders of commercial paper and securities repurchase agreements.

The financial industry’s SPOE plan relies on a two-part funding strategy to guarantee continued protection for Wall Street creditors. First, each SIFI’s holding company would issue long-term “bail-in” bonds. The FDIC would convert bail-in bonds into equity when a SIFI fails, thereby imposing losses on bail-in bondholders as well as shareholders. To avoid the risk of contagion, SIFIs would not sell bail-in bonds to other large financial institutions. Instead, SIFIs would sell bail-in bonds to non-systemic investors, including retail mutual funds and pension funds that invest the savings of ordinary individuals. Thus, ordinary investors would be the primary losers when bail-in bonds are converted into equity.

Second, if write-offs of bail-in bonds are not sufficient to recapitalize a failed SIFI and its operating subsidiaries, the FDIC would borrow the rest of the needed funds from the Treasury Department through the Orderly Liquidation Fund (OLF). Because the OLF currently has a zero balance, OLF loans would be backstopped by taxpayers. Wall Street’s SPOE plan would use OLF loans to ensure full protection for short-term creditors of a failed SIFI’s holding company and all creditors of its operating subsidiaries.

At the end of the resolution process, a new SIFI would emerge with a minimum of structural changes. Thus, contrary to Title II’s liquidation-only mandate, the financial industry’s SPOE plan would reorganize failed SIFIs and guarantee bailouts for Wall Street creditors. Society – whether in the form of bail-in bondholders or taxpayers – would be left holding the bag once again.

U.S. and foreign regulators have not yet formally adopted SPOE, but it appears very likely that they will do so. Given that reality, policymakers must adopt three major reforms to reduce the TBTF subsidy inherent in SPOE. First, SIFIs should be prohibited from selling bail-in bonds to ordinary individuals, retail mutual funds, or pension funds unless those bonds are expressly designated and marketed as subordinated debt that is junior to the claims of all general creditors. The foregoing prohibition would prevent megabanks from misleading ordinary investors by selling bail-in bonds that are described as “senior” to subordinated debt (and therefore pay lower interest rates) but in fact have complex, high-risk “triggers” for conversion into equity. Ordinary investors do not have sufficient expertise to evaluate the risks of those types of bail-in bonds, and such bonds should be sold only to accredited investors.

Second, SIFIs should pay risk-adjusted premiums to prefund the OLF at a level of $300 billion or more. The prefunded OLF should be used to cover the costs of resolving failed megabanks after the FDIC has written off investments by their shareholders, holders of subordinated debt, and accredited holders of bail-in bonds. Prefunding the OLF would help to protect taxpayers from bearing the costs of resolving failed megabanks. In addition, a well-designed, risk-based schedule for OLF premiums would encourage SIFIs to follow more prudent operating strategies and adopt less complex business structures.

As part of their OLF premiums, SIFIs should pay fees on their uninsured deposits and shadow banking liabilities. Under SPOE, those deposits and liabilities would receive full protection and would enjoy a status similar to insured deposits. The required fees should be comparable to risk-based deposit insurance premiums and should encourage megabanks to establish more stable, longer-term funding structures.

Third, federal regulators should adopt long-delayed incentive compensation rules under Section 956 of the Dodd-Frank Act. Those rules should require SIFIs to pay at least half of their total compensation to senior executives and other key employees (including risk managers and traders) in the form of contingent convertible bonds (CoCos). Insiders should be required to hold their CoCos, without any hedging, for several years after their employment ends. CoCos would expose insiders to immediate losses – without any need for clawbacks – if their SIFI fails during their employment or during their post-employment holding period. CoCos would therefore encourage insiders to adopt sustainable, long-term business strategies that are more closely aligned with the interests of long-term creditors, the FDIC, and taxpayers.

The foregoing reforms would not eliminate the TBTF subsidy for SIFIs. However, the reforms would compel megabanks and their insiders to internalize at least some of the systemic risks they impose on society. The reforms would also support other initiatives by regulators – including stronger capital and liquidity requirements and living wills – that seek to encourage SIFIs to reduce their size and complexity.

The preceding post comes to us from Arthur E. Wilmarth, Jr., Professor of Law at the George Washington University Law School. The post is based on his recent article, which is entitled “The Financial Industry’s Plan for Resolving Failed Megabanks Will Ensure Future Bailouts for Wall Street” available here and forthcoming in 50 Georgia Law Review (2015).