The orderly liquidation authority (“OLA”) contained in Title II of the Dodd–Frank Act, created a new regime for receivership of nonbank financial companies whose failures “would have serious adverse effects on the financial stability in the United States.”1 As such, OLA is intended to offer regulators an alternative to bankruptcy proceedings. However, the FDIC has stated that bankruptcy remains the preferred resolution procedure despite the availability of OLA.2 OLA applies to “financial companies,” which includes BHCs, nonbank financial companies that have been designated as systemically important, and certain registered brokers and dealers.3
In order to be placed into receivership under OLA, the “covered” financial company must be designated as posing systemic risk in the event of failure, and it must be in default or in danger of default. The determination is made on the eve of bankruptcy by the Federal Reserve and FDIC with final approval by the Treasury Secretary upon consultation with the President. The decision to place a troubled financial institution under OLA is entirely separate and distinct from the determination of whether a nonbank financial institution is systemically important, with the associated consequence of Fed supervision. Use of OLA authority has been highly contentious, with some lawmakers asserting it will lead to more bailouts due to availability of Treasury funding described below. Whatever the merits of the contention, OLA designations will be politically charged. The upshot being that whatever the virtues of using OLA, its actual usage, even for important financial institutions, is far from assured. Short-term creditors, uncertain whether their institution will fall under OLA, and whether they will actually be protected if the institution was under OLA, will likely run well in advance of an OLA coverage determination being made. In this case OLA resolution would be too little too late to stem contagion.
Once the company is under OLA, the FDIC has broad authority to resolve the insolvent firm. The FDIC, in conjunction with the Bank of England, has stated its preference for a “single-point-of-entry” (SPOE) approach to resolving failed financial companies.4 Under this approach the FDIC would be appointed as receiver to the top-tier parent of the failed holding company, in the case of banks, the BHC. Of course, FDIC would also have authority over the bank subsidiaries’ resolution through its traditional bank resolution authority.5 The first step would be the creation of a “bridge financial company,” essentially a new financial service holding company, such as a bank holding company, where all the assets, primarily investments in subsidiaries, and a limited amount of the liabilities of the failed holding company would be transferred. The equity, subordinated debt, and senior unsecured debt of the failed holding company would be left behind as claims in a receivership, basically holding bad assets, to absorb the losses that triggered resolution. The receivership itself would hold the equity in the bridge financial company. Ultimately, upon valuing the bridge company equity, with consultation from accountants and investment bankers, the FDIC will issue new debt and equity securities of the bridge financial company, based on that valuation, to satisfy the claims of the receivership creditors.6 The FDIC estimates that the valuation process and new issuance of securities will take six to nine months, during which time the bridge financial company will remain under FDIC control.7
The FDIC envisions that the swift creation of a well-capitalized bridge holding company will allow the bridge company to provide the necessary holding company support to its operating subsidiaries.8 Furthermore, if either the parent or the subsidiaries are in need of temporary liquidity that the bridge holding company cannot obtain in the private market, the Dodd–Frank Act authorizes an orderly liquidation fund (OLF), funded by the Treasury, with proper approvals, to provide temporary funding to the bridge holding company, through the FDIC, secured by parent-level or subsidiary assets.9
In establishing a bridge financial company that is able to provide liquidity and necessary capital injections to operating subsidiaries, the SPOE approach aims to ensure that subsidiaries can continue operations without any restructuring. This is a clever solution to the potential problem of intervening at the operating subsidiary level where normal creditor priorities could require short-term unsecured creditors to absorb losses, thus triggering contagious runs. SPOE leaves all creditors of the operating subsidiaries, short- or long-term, unaffected by the restructuring. However, it bears noting that if the SPOE approach was able to successfully protect uninsured short-term creditors at the subsidiary level, then it could actually increase the overall riskiness of the consolidated banking organization. This is because uninsured bank creditors would now no longer have incentives to monitor and impose discipline on bank risk-taking. Indeed empirical studies have found that the discipline provided by uninsured bank creditors has reduced the cost of issuing long-term debt.10 If the SPOE approach were to protect uninsured creditors from the risk of losses, then it would reduce these creditors’ incentive to provide such discipline.
One important reason for the FDIC to be focused on use of SPOE at the holding company level is because its powers to protect the creditors of banks under the Federal Deposit Insurance Act, as amended by the Dodd–Frank Act, has been severely limited by the elimination of open bank assistance, which allowed the FDIC to provide loans, purchase assets, assume liabilities, and even provide cash contributions in order to prevent an insured bank from failing.11
For there to be a successful restructuring of the holding company under OLA, there must be enough long-term unsecured liabilities that can be bailed in or otherwise used together with any remaining equity to recapitalize the parent holding company on a consolidated basis at a sufficiently strong level (e.g., Basel III common equity tier I = 7 percent of RWA). A stable, adequately capitalized consolidated holding company is important to the continuing operation of the subsidiaries since customers and trading partners of the operating subsidiaries may pull their business if the consolidated holding company is still unstable, which could put the subsidiaries, and their creditors, at risk of failure. In addition the long-term unsecured liabilities used to recapitalize the parent holding company must be structurally or legally subordinate to short-term unsecured liabilities at the parent or operating subsidiary levels to reduce or eliminate the potential for contagion among short-term unsecured creditors throughout the financial system (albeit this cannot by itself stop contagion). The line between long-term and short-term unsecured liabilities could be drawn in a number of ways, for example liabilities with an original maturity of a year (some of which may be much less at the time of a run) or a remaining maturity of 30 days following the liquidity approach of the BIS. Unless long-term unsecured liabilities at the holding company level are legally subordinate to short-term liabilities at the holding company level, there must be no material amount of short-term liabilities at the holding company level in order to reduce or eliminate the risk of a run against the holding company.
Under OLA, the FDIC could use its authority to provide liquidity to the operating subsidiaries (e.g., banks or broker-dealers) by having the bridge financial company borrow from the Treasury’s OLF. The bridge financial companies may last for only two years, or up to five years with extensions.12 The FDIC may not use the OLF to capitalize the operating subsidiaries. However, the FDIC may lend the money to the holding company, which could downstream the proceeds to the operating subsidiaries in the form of capital, so the prohibition of FDIC itself recapitalizing the subsidiaries is somewhat meaningless. Any borrowing from OLF must be paid back with a reasonable rate of interest. If the assets of the company are insufficient to do so, then funding must be clawed back from creditors or assessed on other financial institutions. There are also limitations on how much can be borrowed. In the first 30 days, before the FDIC has had the opportunity to determine the real value of the company’s assets, it can borrow only 10 percent of the assets reported on the company’s last financial statement.13 After that period, once the FDIC has established the “real” value, it may borrow up to 90 percent of the fair value of the assets. Provision of Treasury funding will be intensely political, as it will likely be attacked as another bailout.
In an effort to ensure recapitalization, the FSB released in November 2014 a Consultative Document on the Adequacy of Loss-Absorbing Capacity of Global Systemically Important Banks (G-SIBs) in Resolution.14 In the US context, given the SPOE approach, the FSB standards would apply to holding companies but for banks in other countries it could apply at the bank level. The Consultative Document defines international standards for minimum amounts of total loss-absorbing capital (“TLAC”) to be issued by G-SIBs. Under the proposal the top-tier parent company of a US G-SIB will be required to issue eligible securities (“TLAC Instruments”) in an amount at least equal to 16 to 20 percent of the consolidated group’s RWA and at least 6 percent of its total assets.15 This requirement excludes from TLAC Basel III discretionary countercyclical buffers, capital conservation buffers, and G-SIB surcharges.16 Therefore a G-SIB with no countercyclical buffer, but with a standard 2.5 percent capital conservation buffer and a 2.5 percent G-SIB surcharge would effectively be required to hold 21 to 25 percent of RWA in TLAC Instruments.17 The TLAC proposal does not explain why excluding buffers and surcharges is necessary. The FSB intends to select an actual value from the 16 to 20 percent range after conducting a Quantitative Impact Study (“QIS”). The QIS will evaluate consequences of the TLAC requirement, including bank funding costs and the historical record of bank losses and recapitalization needs. TLAC Instruments issued by one G-SIB cannot be held by another G-SIB.18 On October 30, 2015, the Federal Reserve Board released its TLAC proposed rule, requiring domestic G-SIBs to hold minimum TLAC of 18 percent of risk-weighted assets and U.S. operations of foreign G-SIBs to hold 16 percent.19
TLAC Instruments must be unsecured,20 and must have a minimum remaining maturity of at least one year.21 In addition TLAC Instruments must be contractually or statutorily subordinated to a broad class of excluded liabilities, with limited exceptions.22 Several important excluded liabilities are deposits, structured notes, callable debt, and any liability that is senior to vanilla unsecured debt under bankruptcy law.23 Securities that qualify as Basel III regulatory capital are eligible TLAC Instruments.24 However, the Proposal requires that at least 33 percent of the TLAC requirement must be satisfied with securities that do not qualify as regulatory capital.25 For example, if a G-SIB issued sufficient equity to satisfy 100 percent of its TLAC requirement, it could only count 67 percent of this capital surplus toward its TLAC requirement. The justification for this requirement is not addressed in the proposal.
The Committee on Capital Markets Regulation has estimated that these TLAC requirements will lead to a “total gap to implementation for the eight US G-SIBs between $44.6 billion and $197 billion.”26 This is twice the average monthly issuance of all US corporate debt.27 These estimates accord with other estimates. In particular, the Clearing House has estimated US G-SIB shortfalls between $104 and $195 billion,28 while Standard & Poor’s has estimated a shortfall of between $23.4 and $203.2 billion.29 One concern with TLAC is that if it were ever used to actually recapitalize subsidiaries then the investors holding TLAC debt would experience large losses and as a result, demand for future TLAC debt could dry up.
Quite apart from the recapitalization of the holding company, the bridge holding company must be able to downstream enough capital to absorb the losses in the operating subsidiaries. On the asset side of the holding company, the assets must be in a sufficient amount and eligible to be contributed to the operating subsidiaries. Eligible assets would include any assets held at the parent level that can be contributed to the subsidiaries, such as interests in solvent companies, cash, or portfolio securities, or a reduction or cancellation of loans (which are liabilities of the operating subs).
When considering the downstreaming of assets, the only eligibility restriction is that the subsidiary not be prohibited by regulation from owning the particular assets. For example, an insured bank subsidiary may not be able to own equity securities in a broker-dealer subsidiary that is engaged in activities that the bank is not permitted to engage in directly. In contrast, an insured bank subsidiary could accept the contribution of a receivable from a nonbank subsidiary without violating Section 23A of the Federal Reserve Act because the extension of credit would have been made by the parent, not the bank, and the acceptance of the contribution would not amount to a “purchase” of assets from an affiliate unless an express payment were made or liabilities assumed, which would not be the case here.30
An example of the bail-in of parent-level debt necessary to recapitalize the consolidated entity was illustrated previously in table 16.1, using Citigroup as an example. The point of that example is that bailable debt at the holding company level must be sufficient to cover the losses of the operating subsidiaries—because these losses directly impact their owner, the holding company.
As for the injection of capital into subsidiaries, consider the following example, illustrating the use of parent-to-sub loans for purposes of recapitalizing an operating subsidiary. For simplicity, assume that all assets have equal risk-weighting. Holdco is a bank holding company whose dominant holding is a large bank subsidiary, Bank Sub. In step 1, Bank Sub has tier I capital of $100 billion against RWA of $1.6 trillion, giving it an adequate tier I capital ratio of 6 percent. Holdco has tier I capital of $150 billion against consolidated RWA of $2.5 trillion, and is also adequately capitalized with a tier I capital ratio of 6 percent. In step 2, Bank Sub suffers a $75 billion loss, causing a reduction of its tier I capital to $25 billion. Consequently Bank Sub is in need of a massive capital injection to avoid approaching insolvency and to re-establish an adequate capital ratio. Furthermore, as a result of this loss to Bank Sub, Holdco’s tier I capital has also been reduced by $75 billion to $75 billion and Holdco is no longer adequately capitalized itself. Holdco needs to raise $75 billion in new capital to maintain an adequate capital ratio, which can be done through the bail-in of Holdco level debt. In step 3, a bail-in of $75 billion of Holdco level debt converts $75 billion of that debt into $75 billion of common equity, providing the necessary capital increase for Holdco. Holdco has increased its tier I capital back to $150 billion and is adequately capitalized. However, while the bail-in of Holdco level debt has re-established an adequate capital ratio for Holdco, Bank Sub has not yet received any new capital. Bank Sub continues to be inadequately capitalized with $25 billion of tier I capital and is in need of a $75 billion injection from Holdco. The question is: how does Holdco provide fresh capital to Bank Sub?
The main channel for injecting capital from Holdco to Bank Sub is through the cancellation of debt owed by Bank Sub to Holdco. Assume, as in figure 17.1, Holdco has a loan outstanding to bank sub in the amount of $100 billion. In step 4, Holdco can inject $75 billion of capital into Bank Sub by canceling $75 billion of the Debt-to-Holdco loans, which will increase Bank Sub’s common equity by $75 billion. As a result Bank Sub’s tier I capital is restored to $100 billion and it becomes adequately capitalized once again. Figure 17.2 illustrates this transmission mechanism.
Capital downstream example
At the same time, Holdco’s capital remains at $150 billion after the cancellation of the loans. So long as the necessary capital injection is less than the amount of the Holdco-to-Bank Sub loan, this transmission channel will work for re-capitalizing a troubled subsidiary. However, if Bank Sub’s initial loss were greater than $100 billion (the amount outstanding of Holdco-to-Sub loans), then a further transmission mechanism would be necessary, or losses would be imposed on the creditors of the bank subsidiary, including short-term uninsured creditors.
These holding company-to-subsidiary loans are common arrangements in US BHCs and could potentially serve as an adequate transmission channel for injecting capital into subsidiaries.
Top 10 US bank holding company subsidiary data on loans to subs (USD millions)a
Table 17.1 shows a snapshot of the top 10 largest US BHCs and their respective largest bank subsidiaries as of March 31, 2012. These data provide insight into the potential for cancellation of holding company loans to subsidiaries as the primary transmission channel for injecting capital. The final column shows holding company-to-subsidiary loans as a percentage of the bank subsidiary’s tier I capital. While more specific loan detail is necessary for a complete analysis of intercompany loan cancellations as a viable transmission channel, this establishes an upper bound on the percentage of each bank subsidiary’s tier I capital that could be injected through the cancellation of loans from the holding company to the bank subsidiary. For example, JPMorgan Chase & Co. (holding company) has its largest bank subsidiary, JPMorgan Chase Bank, NA (bank sub) holding $100.8 billion of tier I capital. JPMorgan Chase & Co. also has $40.8 billion of loans outstanding to its bank subsidiaries. If the entirety of those loans were to JPMorgan Chase Bank, NA,31 JPMorgan Chase Bank, NA, could suffer up to a 40.47 percent loss of tier I capital that could be injected by the holding company through a cancellation of the $40.8 billion of loans. In its “Public Resolution Plan” submitted to the Federal Reserve as required by Dodd–Frank, JPMorgan does indeed indicate its intention to use the cancellation of intercompany loans as the primary mechanism for recapitalizing troubled bank subsidiaries under a Title II resolution.32
However, any substantial loss that severely impacts a bank subsidiary’s balance sheet (i.e., losses that approach or result in insolvency) may not be sufficiently offset by a cancellation of the intercompany loans, since not every bank is like JPMorgan in this respect. In particular, half of the banks would be unable to support losses greater than 25 percent of tier I capital through cancellation of intercompany loans. In such cases of severe losses, the cancellation of intercompany loans is unlikely to be a sufficient means of injecting capital from the holding company into the bank subsidiary.
For this method of recapitalization to work, the regulators would have to require that important financial holding companies have sufficient debt to their operating subsidiaries (e.g., banks and broker-dealers), what some have called internal TLAC. This may be problematic for institutions whose operating subsidiaries do not need funding from the holding company do to their reliance on funding at the operating subsidiary level. This would be particularly true for retail banking organizations with a wide base of retail deposits. An intercompany loan requirement would require the holding companies to provide funding to banks that did not need or could not use it, imposing a substantial dead weight loss on such institutions.
Under the Bankruptcy Code derivatives counterparties facing a failing institution have a safe harbor that allows a nonfailing counterparty to terminate the derivative contract and take its collateral.33 Normally, in bankruptcy all seizures of collateral are subject to an automatic stay that prevents such seizures. This safe harbor has the potential to impose further losses on the insolvent institution, and can accelerate its decline, as happened with Lehman. For example, Lehman owed one of its derivatives counterparties, JPMorgan, approximately $20 billion. Due to the derivatives safe harbor, JPMorgan was able both to freeze $17 billion of its Lehman collateral and to make a $5 billion collateral call days before Lehman’s bankruptcy filing.34 Although it may be difficult to quantify the value destruction that resulted from early termination, this accelerated imposition of losses undoubtedly contributed to overall losses to the estate that—according to Federal Reserve researchers—“could have been avoided in a more orderly process.”35
OLA, however, like bank resolution conducted by the FDIC, institutes a one business day stay on the ability of counterparties to exercise their right to terminate, during which time the FDIC may find a third-party buyer to take the place of the nonfailing counterparty. In a bank holding company, derivative positions are either all held at the bank or operating subsidiary level, or held through SIVs that have higher credit ratings than the bank holding companies, rather than held at the holding company level. In the case of a large financial institution, finding such a buyer, especially in such a short period, is unrealistic given the difficulties in valuing a large and complicated derivatives book. It is more likely, that the stay would allow the authorities to restructure the holding company, and then to recapitalize its subsidiary banks, so that the banks were now solvent, such that their counterparties no longer had the right to terminate their contracts. There would be little to gain by transferring the banks’ derivatives positions to the holding company which, unlike the banks, would not have access to discount window liquidity—as we have seen access for nonbanks (including holding companies) under Section 13(3) is much more problematic. Further, under the single point of entry policy, banks whose obligations would not be restructured, should have higher credit ratings than holding companies that can be restructured.
Although OLA imposes a stay on early termination rights, this restriction does not necessarily apply to swaps governed by foreign law or in a US non-OLA bankruptcy.36 Under pressure from resolution authorities, in 2014, eighteen of the largest global dealer banks agreed to a stay of the longer of one business day or 48 hours (e.g., a weekend) on their derivatives termination rights in the event of a counterparty’s bankruptcy.37 Thus, if a counterparty enters bankruptcy, the largest dealer banks could not immediately terminate their open derivatives contracts with that counterparty or seize collateral from that counterparty. This could further facilitate leaving the derivatives book with the recapitalized banks. Global policy makers (particularly members of the FSB) are seeking to encourage additional derivatives counterparties to participate in this agreement, including through pursuing regulatory changes in their respective jurisdictions.38 As of October 7, 2015, a total of 186 derivatives counterparties around the world had agreed to participate in this stay.39
The use of the SPOE approach, as envisioned by the FDIC, requires cross-border cooperation of regulators to be successful. While SPOE resolution may be feasible when implemented within a single country, it becomes a much more difficult process across borders. In the case of OLA, the FDIC will need to give credible assurances to foreign authorities that subsidiaries operating within their borders will be given fair treatment regarding capital and liquidity injections.40 In addition, the FDIC must ensure that the resolution strategy will preserve the critical functions operating in foreign jurisdictions.41 Finally, equity holders and creditors must be given equitable treatment across borders.42 Failure to credibly provide any of these assurances may induce a foreign jurisdiction to take independent action, thus disrupting a SPOE resolution.
In addition the United States may be concerned about the treatment of US subsidiaries of foreign banks when a foreign jurisdiction is in charge of the resolution of these entities—the failure of a foreign jurisdiction to adequately recapitalize US subsidiaries could give rise to losses for US creditors and could spark contagion in the United States. In the past the United States has ring-fenced the assets of foreign banks in the United States to provide the resources to protect US creditors.43 To protect US creditors in foreign subsidiaries, the Federal Reserve has issued a final rule requiring foreign banking organizations to establish intermediate US holding companies in the United States with sufficient capital to cover losses of US subsidiaries.44 This proposal has sparked foreign criticism and risks retaliation from other jurisdictions requiring their own intermediate holding companies for foreign banking organizations, such as the United States. This system of ring-fenced “trapped” capital is highly inefficient and significantly increases the capital needed by all multinational banking organizations.
The FSB has also envisioned a multiple-point-of-entry (“MPOE”) approach in which various regulators intervene at different levels of a banking organization, namely some at holding company (or intermediate holding company) level and others at the operating sub (e.g., bank) level. This approach also requires cross-border cooperation to “avoid conflicts or inconsistencies that undermine the effectiveness of the separate resolution actions, a disorderly run on assets, and contagion across the firm.”45 Authorities must also agree to the scope of their respective resolution procedures to avoid a competition for assets of the firm, which would have a destabilizing effect. All of these international complications make the successful use of SPOE somewhat problematic.
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The most important point about resolution, under the Bankruptcy Act, the FDIA or OLA, is that short-term creditors will be at risk, and thus contagion will not be abated; resolution helps with contagion but cannot by itself avoid it. Uninsured creditors have no priority under the Bankruptcy Act or FDIA, and recapitalization of the operating subsidiaries under OLA is far from certain. Institutions may never get to OLA, so their creditors will run fearing disposition under Bankruptcy; even if OLA were to apply, there is no guarantee that a method could be found to adequately recapitalize the operating subsidiaries, or that SPOE can be successfully deployed internationally. And these procedures have never been tested, let alone with the failure of a G-SIB or SIFI. We may pray that they will work but creditors who can run are not assured by prayers.
This is not to say resolution procedures are not important—they can preserve franchise value, minimize private and public losses, and permit large institutions to fail. And by minimizing the impact on short-term creditors they can help to avoid triggering or exacerbating contagion.
But even if resolution procedures were perfected their existence will not remove the need for a strong lender of last resort.46 Runs can still occur at operating subsidiaries even with capital injections. Indeed, there is likely to be reputational contagion from the insolvent parent company to the solvent subsidiaries, leading to depositor flight from otherwise solvent subsidiaries.47 Historical evidence supports this interpretation.48 Short-term creditors would likely still redeem to be absolutely sure that they would not be hit with the costs of a creditor bail-in.49 And creditors of institutions not in resolution but that could be will likely run—better safe than sorry. Effective resolution cannot by itself avoid contagion, and without weapons to fight contagion, placing a significant financial institution into resolution may itself ironically spark contagion.