Too Big and Unable to Fail

Financial regulation after the Dodd-Frank Act was enacted in 2010 has produced a blizzard of acronyms, many of which revolve around the basic “too big to fail” problem.  OLA, OLF, SPOE, and TLAC are new regulatory tools that seek to build a regime for resolving failures of systemically important financial institutions.  “Resolution” is the financial industry’s favored term for what most people would simply call “bankruptcy” or, more politely, “restructuring.”

The explicit goal of this new “resolution” regime is to enable a large financial institution (or SIFI, to use another favored acronym) to go bankrupt without a government bailout.  Just like United Airlines, Borders Books, or Blockbuster Video, or any other big business that has filed under chapter 11 of the Bankruptcy Code.

In our paper, forthcoming in the Florida Law Review and available here, we express significant doubts about the new regime’s ability to work as advertised.

We begin with SPOE (or single point of entry), which is a plan for resolving a financial institution that focuses on the parent holding company.  Basically, the holding company would enter some sort of resolution process, while the operating subsidiaries would carry on as if all was right in the world.

We view SPOE as a strategy devised for a very stylized, even hypothetical sort of failure, of dubious connection to the real world.  SPOE is unlikely to work as intended during a future global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries.

The Federal Reserve’s TLAC (or total loss absorbing capacity) proposal is closely tied to SPOE. It would require parent holding companies of SIFIs to issue large amounts of debt securities that can be “bailed in” (written off or converted into equity) in a resolution proceeding.  If SPOE and TLAC have any hope of success, it turns on the ability to make the holding company solvent again by forcibly converting bondholders into shareholders.  However, it is not immediately apparent why such forced conversions will be successful in reviving an insolvent SIFI.  Simply converting debt into equity doesn’t infuse any new money into a sick institution.

In our view, TLAC debt will also create a new, more opaque way to impose the costs of financial distress in SIFIs on ordinary citizens, because most TLAC debtholders who could lose their standing as creditors are likely to be retail investors in brokerage accounts, mutual funds, and pension funds.

The most fundamental shortcoming of SPOE and TLAC, as currently proposed, is that both policies would entrench our perverse system for regulating SIFIs. Our current regulatory system enables SIFIs and their Wall Street creditors to reap massive benefits from the TBTF (too big to fail) subsidy while imposing the costs of that subsidy on ordinary citizens.

We recognize that a new and improved version of Dodd-Frank is unlikely to emerge soon from Congress. However, regulators should use their existing powers to shrink the TBTF subsidy by forcing SIFIs and their Wall Street creditors to internalize at least some of the costs of the enormous risks they create.

The final part of our paper proposes strategies that would help to achieve that goal.  In particular, we argue that SPOE is better viewed as just one of many possible tools in the resolution tool box.  Thus, we reject pending “chapter 14” proposals that would tie financial institution resolution under the Bankruptcy Code to the exclusive use of the SPOE approach.

In addition, we argue for strong “black box” style warnings in connection with the sale of TLAC debt, similar to warnings that many brokerage firms already use when they sell junk bonds to investors. An example might be, “This bond will incur losses in a financial crisis; you could lose your entire investment.” Thus, mutual funds or pension funds that invest in TLAC debt should disclose the bail-in risks to investors and should include in their offering materials the “black box” warnings proposed in our article.  Each such fund should also disclose the maximum percentage of the fund’s assets that could potentially be invested in TLAC debt, and the possible correlation and contagion risks presented by such debt, even if issued by multiple SIFIs.

We further propose that each SIFI that issues TLAC debt should maintain a dedicated web page addressing its resolution plan.  On that page, the company should set forth, in both text and diagrams, the complete “waterfall” for allocating losses incurred by the parent holding company among holders of its equity and debt securities.  Based on that “waterfall” disclosure, current or prospective TLAC debtholders should be able to ascertain the point at which they will begin to incur losses, and the point at which their entire investments will be vaporized.

Each SIFI’s resolution web page should also contain a straightforward discussion of the role of TLAC debt in the SIFI’s capital structure.  TLAC debtholders should be clearly told that their claims are deeply subordinated, and that they are taking on risks that creditors and counterparties of operating subsidiaries are unwilling to assume.  Only with such disclosures can we be reasonably confident that the hazards of TLAC debt will be appropriately priced by the market.

Finally, the parent holding company of each SIFI should be required to maintain dedicated liquidity reserves that would enhance the likelihood of a successful resolution if its TLAC debt is forcibly converted into equity.

This post comes to us from Professor Stephen J. Lubben of Seton Hall University School of Law and Professor Arthur E. Wilmarth, Jr. of George Washington University Law School. It is based on their article, “Too Big and Unable to Fail,” available here.