GWU School of Law Presents Financial Stability After Dodd -Frank: Have We Ended Too Big to Fail?
Key Topics & Takeaways
- Too Big To Fail: Richmond Fed President Lacker stated that financial reforms have not ended the problem of “too big to fail” financial institutions and that “strengthening regulatory restraints on risk-taking” and are important.
- International Resolution: Former Bank of England Deputy, Tucker said it “verges on fantasy” to think that large and complex banks could be resolved without some type of international treaty, but noted there is “very little appetite” for such a treaty.
- SPOE: Panelists supported the single point of entry strategy as being the best way to resolve large firms with cross-border operations
- Living Will Disclosure: Hoenig stated that all sections section of living wills should be publicly disclosed, unless the firms can explain why certain parts are proprietary, to allows the market to judge the strength of a firm and Congress to assess if bankruptcy will work.
- FSB Structure: FDIC Director Jeremiah Norton spoke against the structure of the Financial Stability Board, specifically with the makeup of representation that includes just three American regulators but twenty from Europe.
- Shadow Banking: IMF Deputy Director Ceyla Pazarbasioglu said shadow banking can be a good thing, and that risks must be balanced against its benefits. She advocated for the need to fill data gaps to make effective regulation.
- Executive Compensation: Jeremiah Norton supported TBTF executives having more incentives to look after long-term institutional stability through equity incentives. Arthur Wilmarth suggested that bail-in debt would give them “long-term skin in the game.”
Speakers
- Jeffery Lacker, President of the Federal Reserve Bank of Richmond
- Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation (FDIC)
- Simon Johnson, Professor at the Sloan School of Management, MIT and Senior Fellow at the Peterson Institute for International Economics
- Paul Tucker, Senior Fellow at Harvard School of Government and former Deputy Governor or the Bank of England
- Jim Wigand, Partner at Millstein & Co. and former Director of the FDIC’s Office of Complex Financial Institutions
- Jay Westbrook, Chair of Business Law at University of Texas at Austin School of Law
- Anat Admati, Professor of Finance at the Stanford Graduate School of Business
- Jeremiah Norton, Director, Federal Deposit Insurance Corporation
- Henry Hu, University of Texas School of Law
- John Parsons, Sloan School of Management, MIT
- Thomas Cooley, New York University
- Martin Hellwig, University of Bonn
- Ceyla Pazarbasioglu, Deputy Director, Monetary and Capital Markets Department, International Monetary Fund
- Zoltan Poszar, Senior Advisor, Office of Financial Research, Treasury Department
- Arthur Wilmarth, George Washington University School of Law
Keynote – Jeffery Lacker
Jeffery Lacker, President of the Federal Reserve Bank of Richmond, gave the first keynote address and stated that financial reforms have not ended the problem of “too big to fail” financial institutions. He said that fundamental problems stem from market participants expecting government support of stressed financial institutions and because politicians feel compelled to provide this support. He added that this perception of government intervention encourages fragility in the financial system and noted that there is ambiguity about the scope of any future government support.
Lacker stated that “strengthening regulatory restraints on risk-taking” are important measures to “reduce the likelihood of distress,” but that regulators “must realign the incentives of financial market participants” by removing expectations of government intervention. He stated that if firms and creditors do not expect government support, they will limit their risk taking, which would help avoid over-reliance on bank supervisors.
Lacker highlighted that bankruptcy for large financial institutions “offers many advantages” including collective proceedings and having costs ultimately borne on creditors and other stakeholders. He stated that proposed strategies to vest a firm’s losses at the parent company “might not be the most effective to restore market discipline” and that exemptions from termination stays for short-term financing instruments “arguably over-encourages” use of such instruments and “enhances the growth and fragility of shadow banking.”
He concluded that “credible commitment to orderly unassisted resolutions” may require eliminating the government’s ability to provide ad hoc rescues including “repealing the Federal Reserve’s remaining emergency lending powers and further restraining the Fed’s ability to lend to failing institutions.”
Question and Answer
An audience member asked if the Fed will stop characterizing derivatives as non-cash flow items. Lacker replied that treatment of derivatives is an “important and complicated topic” and said that safe harbor treatment under resolution processes “have gone too far” and “over-encourage” the use of derivatives over other arrangements.
Paul Tucker, former Deputy Director of the Bank of England, asked what the duties of the courts would be in a cross-border bankruptcy and how jurisdiction would be claimed on branches and subsidiaries. Lacker said that two possible paths can be pursued: 1) cooperation between countries on a “planetary view;” and 2) severability and compartmentalization of each jurisdiction. He said that whatever path is taken, a resolution in one jurisdiction should not prevent the operations of a subsidiary in another.
Another question asked what tools the FDIC will use if the next living will submissions are deemed “non-credible.” Lacker responded that the Fed gave a “fairly comprehensive” set of instructions to firms on what to improve in their submissions but said he does not think the regulatory community has “defined what is sufficient.” This, he said, is a “symptom” of “learning as we go.” He later added that the Fed will work to “enhance the visibility” of living wills through more public disclosure, so that creditors know how they will be treated in a bankruptcy.
When asked if the Fed’s 13.3 authority threatens to turn the central bank into a “market maker of last resort,” Lacker said that he is “skeptical of having the government second guess market prices.”
Another question asked how the Fed is preparing firms for interest rate risk. Lacker noted this preparation has been part of the Fed’s supervisory process for decades and that they assess firms under various scenarios.
When asked how funding a firm works during a bankruptcy, Lacker highlighted that firms have “built substantial liquidity buffers” and have reduced their reliance on short term funding. He added that regulators will “need to work backwards” from a situation where firms provide the liquidity themselves to where firms are now.
Session 1 – Will “Orderly Failure” Work for Large Complex Institutions
Simon Johnson, Professor at MIT, began the discussion by asking “where we stand now” in terms of the bankruptcy process and development of Dodd-Frank Title I.
Jay Westbrook, Chair of Business Law at the University of Texas at Austin School of Law, said that the government would have to fix the bankruptcy code as it currently stands to allow a large institution to use it, noting that the court system is “not nearly fast enough now.”
Jim Wigand, former Director of the Office of Complex Financial Institutions at the FDIC, said that the “vast majority” of holding companies could go through the bankruptcy and insolvency framework under Title I, but noted that a “handful of firms” could cause systemic problems.
Paul Tucker replied that it “verges on fantasy” to think that large and complex banks could be resolved without some type of international treaty, noting there is “very little appetite” for such a treaty and said regulators would need to ring fence entities in different legal jurisdictions.
Johnson then asked what types of actions are considered bailouts.
Wigand said there is a “continuum of support” action that can be considered a bailout, but that liquidity support “has not been viewed historically as a bailout.” He said liquidity allows for a more orderly process and said there needs to be “firewalls in the system” to protect taxpayers.
Tucker said it is essential that central banks do not lend to insolvent firms and said it is “strange” that Dodd-Frank provides for a line of credit from the Treasury in resolution processes. He then explained that the best resolution strategy would be for subsidiaries to issue equity and super-subordinated debt to their holding company and transfer their losses to the holding company so that the subsidiary does not default. He said if this strategy does not succeed “banks will have to be broken up.”
Westbrook said the strategy outlined by Tucker is similar to the “single point of entry” (SPOE) strategy and noted that “liquidity is the key.” He said that liquidity will have to come from a government agency if there is not enough at the firm to give confidence to the market.
Wigand stressed that the SPOE is a “strategic approach to resolution” and that it does not have to be applied under Title II, and explained that the strategy structurally subordinates creditors by creating a hierarchy outlining who will bear losses of the firm. He added that long term investors are better positioned to promote better incentives for the level of risk taking.
Question and Answer
An audience member asked who will be the ultimate holders of assets that “insure the entire system” during a systemic event. Tucker replied that he hoped to see part of this answer come out of the next G20 meeting in Brisbane and added that regulators “cannot allow banks and shadow banks” to ultimately hold these assets. This leaves insurance funds and mutual funds to hold those assets, he concluded, noting that these are ultimately owned by households. He also noted there is an “agency problem” for households when giving their money to these institutions. Wigand agreed that there is an agency issue involved with holding assets but explained that what matters is who holds the credit risk associated with the investment instruments. Johnson later added that if asset managers are ultimately the holder of these bonds, it may “bring into question” asset managers as systemically important financial institutions (SIFIs).
The next question asked how to avoid “pillaging of subsidiaries” during a resolution. Tucker replied that regulators of a subsidiary will ring fence the entities if they do not trust the regulator of the holding company and that this strategy will force regulators to face their beliefs and their trust of other authorities. Westbrook added that governments around the world need to take on the burden of being a host country.
Another audience member asked how much equity relative to “total loss absorbing capacity” (TLAC) should be held. Tucker said that even if equity requirements of Basel III are not the best solution there will still be discipline of the institutions from bond holders, adding that if investors do not want to hold these bonds, the banks will shrink. Wigand said that “calibration is critical” since equity holders can exercise a put option and sell their shares first.
When asked about derivatives transactions in resolution, Wigand noted that one objection to the SPOE is that derivatives contracts are held at the holding company level with hold company credit support. He said if the subsidiaries maintain continuity of operations then he hopes that counterparties do not have the ability to accelerate and terminate their contracts. Tucker agreed that these contracts need a freeze for resolution to be effective. He then noted that asset managers have not yet signed the ISDA early termination stay protocol and that dealers would be banned from dealing with them if they do not sign it.
Johnson asked the panel if “too big to fail” has been ended. Westbrook said “no;” Wigand said it is “not a question of too big but too connected” and that the “jury is still out” if firms are too connected to fail; and Tucker said that ending “too big to fail” is “absolutely within reach,” added that resolution regimes are better in Europe than in the U.S.
Next, Johnson asked what levels of TLAC should be required. Tucker replied that a level of 20-25 percent of risk weighted assets (RWA) comprised of equity and bonds will likely be required. He added that the Basel Committee is “on course to introduce floors on risk weights” and that he hopes the committee will also address calculation of total assets. Wigand agreed that the likely level will be 20-25 percent with the ability to calibrate.
Keynote – Thomas Hoenig
FDIC Vice Chairman Thomas Hoenig, in his keynote address, stated that the U.S. and global financial systems “are the definition of concentrated risk” because they are composed of institutions that are “highly leveraged, heavily reliant on wholesale funding, and unduly interconnected.”
Hoenig said that shortcomings in firms’ living will submissions “perpetuate uncertainties” around resolution, “negatively affect asset values, raise concerns of contagion, and exacerbate crisis.” He said as the FDIC and Fed work with firms to improve their resolution plans, “CEOs and directors must be fully engaged and confident in their ability to take their firms through bankruptcy.” He then highlighted the following as important issues moving forward: 1) capital; 2) liquidity; and 3) structure and cross-border challenges.
On capital, Hoenig stated that while “no amount of equity capital can save an individual firm from the consequences of poor management,” sufficient levels of equity enable managers to survive “errors in judgment.” He then stated that “firm and industry resilience is still sorely lacking.” He criticized RWA calculations saying they “permit firms literally to reduce the size of their balance sheets” and reduce levels of apparent leverage. He said a better calculation of risk is the Global Capital Index, which he developed, and noted that using this model, regional banks have “roughly double” the capital level that SIFIs do. He added that the “portion of the financial industry with the greatest concentration of assets is the least well prepared to absorb loss.”
On liquidity, Hoenig stated that in anticipating a bankruptcy a firm should “assume the worst” in a liquidity shock and outline how broker-dealer and other affiliates “will access sufficient unencumbered assets to provide debtor-in-possession financing.” He noted the early termination stays for derivatives and said that “more of this kind of work is needed” to mitigate the liquidity challenges and those similar actions may be needed “for those parts of the repo book that use long-term assets to secure short-term funding.”
On structure and cross-border challenges, Hoenig explained that complexities in corporate structure, including inter-dependencies and cross-border activities, influence whether a firm can be taken through bankruptcy and noted that thing such as depositor preference and contract enforceability differ in among various countries. One danger, he said, is that affiliates and branches could be subject to “sovereign ring fencing of local funds” which would tie up liquid assets when they are most needed. He added that this is “particularly relevant for broker-dealer activities where volatile wholesale funding is most vulnerable to runs across borders and institutions.”
Question and Answer
Simon Johnson asked how many chances banks will get to improve their living will submissions before the FDIC takes remedial actions. Hoenig responded by noting that the FDIC can increase supervision, raise capital requirements, and force divestures if plans are not credible, but added that the advantage of Title I is the opportunity to force a firm’s structure to be “more amenable to bankruptcy.”
Another question asked how the lender of last resort function of the Fed factors into the living will plans. Hoenig said that each firm is asked for the scenario of their “idiosyncratic failure” and thus assumes that they have no liquidity access.
When asked what sections of living wills should be transparent, Hoenig stated that all sections should be disclosed, unless the firms can explain why certain parts are proprietary. He said this transparency is important because it allows the market to judge the strength of a firm and allows Congress to say if bankruptcy will work.
An audience member asked why transaction tests are done at small banks but not larger banks. Hoenig said that transaction tests could be carried out systemically at large banks, adding that he is “not a fan of embedded examiners” and that having more statisticians and fewer econometricians would help in the examination process.
Session Two: Reducing the Fragility of the Financial System
Anat Admati of the Stanford Graduate School of Business moderated a discussion of fragility in the financial system. She said that the too big to fail (TBTF) firms generally have very little equity funding and rely instead on a variety of debt commitments, making them the most indebted institutions in the country. However, she said these structures are not “inevitably inherent,” but rather choices that the institutions have made. She stressed that Title I of Dodd-Frank “requires that we don’t live with this system” and that firms are “living unnecessarily dangerously.”
Admati said there is plenty of discussion on what to do when firms fail, but not enough about solving the reasons for their failure. She called limited disclosures of resolution plans a risk, and said the “biggest can of worms” is opacity in measurements.
John Parsons of the Sloan School of Management at MIT focused his comments on derivatives. He said the easiest part of Dodd-Frank was mandatory trade reporting of derivatives, but that the data being reported to the Commodity Futures Trading Commission (CFTC) is a “mess.” He was critical of the industry being reluctant to surrender data to the CFTC, and said their reporting is “like Swiss cheese” with significant details missing.
Speaking about both regulators and the industry, Parsons commented that “they’re not on top of this.” He called on the CFTC to stop publishing what said is “trash data” and said regulators should not have to assume the full burden of developing reporting conventions, but rather let the industry contribute as well. Parsons said that “as a culture,” we must demand that regulators cannot accept the notion that firm operations are too complex to report.
Henry Hu, University of Texas School of Law, agreed that more disclosures and enhancing public information would be beneficial, saying that “sunlight is a good thing.” He commented that people believe information asymmetry helped cause the crisis.
Hu credited the Federal Reserve for creating a new disclosure universe for TBTF banks. However, he said financial innovation creates new risks that are unclear and called the reporting tools of the new bank disclosures “incredibly crude.” He said intermediaries can have a hard time describing objective realities in such complex systems, and said the possibility of “simplifying reality” by breaking up banks should be researched.
Jeremiah Norton, Director of the FDIC, opened by highlighting regulator efforts to contain systemic risk through mechanisms such as leverage and liquidity ratios, central clearing of derivatives, and regulation of activities through the Volcker Rule, risk retention, and other others.
Norton, however, said these efforts are not enough and that regulators must “push the distance to default out further.” He said regulators must be able to resolve institutions through bankruptcy and stressed that Congress pushed for a way to make this a reality in Dodd-Frank. He lamented that seven years after the crisis, “we’re still not at the right place” and the pace of reform has been very slow.
Norton stated his concern that regulators are relying too much on the Basel process and measurements using risk-weighted assets. He said Basel’s capital requirements are too opaque and allow for instruments of questionable liquidity in times of stress to be counted as capital on par with equity. Norton was also critical of the Financial Stability Board (FSB) for comprising only three representatives from the United States but twenty from Europe despite the fact that Europe now has a single supervisory banking mechanism. He questioned how policy decisions are made with that composition of representation, and commented that the three U.S. representatives “don’t always get along.”
Commenting on TBTF firm executives, Norton stated that they run their institutions without thinking of themselves as long-term owners, and advocated for the need to have them think across economic cycles. He said executives have better responses when equity gives them incentives to think about long-term stability.
Session Three: Industry Structure and the Shadow Banking System
Thomas Cooley, Professor of Economics at New York University, moderated a discussion of industry structure and shadow banking, which he said is very important to the financial system but exists because of regulatory arbitrage.
Martin Hellwig, Professor of Economics at the University of Bonn, said that when thinking about industry structure, the key questions to ask are about the proper structure of governance for the allocation of excess funds, and whether structural reform should be used to make resolution easier. He commented that the industry and its major institutions have grown because of mercantilist policies, the rise of national champions, significant excess capacity, the growth of derivatives, and the increase in inter-institution business. He also stated his belief that the derivatives industry is “inherently unstable.”
Ceyla Pazarbasioglu, Deputy Director of the International Monetary Fund’s (IMF) Monetary and Capital Markets Department, said the FSB had made efforts to deal with the shadow banking sector since 2011, but commented that the development of shadow banking, or non-bank credit intermediation, can be a positive development. She said there is a need for a system to provide credit when banks are unable, but that leverage in the banking system can then migrate to shadow banking.
Pazarbasioglu said shadow banking is very complex and involves so many steps that regulations targeting individual steps are ineffective. She said regulators must work to contain risks while preserving the “good parts” of shadow banking, but the greatest challenge is the form of data gaps. More information is needed, she said, to effectively act on shadow banking.
Asked about regulators’ approach to asset managers, Pazarbasioglu said asset managers do face liquidity risk and suggested that they should be subject to exposure limits. She questioned whether asset managers should be allowed to be too concentrated in a single type of instrument.
Zoltan Poszar, Senior Advisor in the Office of Financial Research, said shadow banking is no longer just the result of regulatory arbitrage. He said the sector exists because of market conditions that have created a demand for wholesale funding and safe short-term investments for cash investors such as FX reserve managers, corporations, and asset managers. He said repurchase agreements and money market funds in the shadow banking sector are a natural place for market participants to go when there are not enough Treasury bills and they cannot put large amounts of money into uninsured bank accounts. Poszar stressed that there can be no solutions to the risks of shadow banking without first understanding the ecosystem in which it exists.
Asked whether there is something fundamental about shadow banking activities that could not take place in regulated sectors, Poszar said the traditional banking system would be unable to fill the gap for some of these asset demands, but that the public sector could be an alternative with the issuance of more Treasury bills or the Federal Reserve’s use of its large balance sheet and reverse repos.
Arthur Wilmarth, Professor of Law at George Washington University’s School of Law, said shadow banking provides different types of funding for the largest institutions, and was very critical of regulatory efforts thus far to combat systemic risk. He said money market fund reform “has been a fiasco,” and that securitization reform has been hurt by the Qualified Mortgage and Qualified Residential Mortgage rules that let banks bundle up mortgages with no down payments. He added that the industry has successfully pushed back on derivatives action despite lots of regulator activity, and that the SPOE approach protects shadow banking mechanisms.
Wilmarth suggested that SIFI executive’s compensation should include significant bail-in debt that they cannot sell to give them “long-term skin in the game incentives” to promote firms’ long-term stability.
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Key Topics & Takeaways
- Too Big To Fail: Richmond Fed President Lacker stated that financial reforms have not ended the problem of “too big to fail” financial institutions and that “strengthening regulatory restraints on risk-taking” and are important.
- International Resolution: Former Bank of England Deputy, Tucker said it “verges on fantasy” to think that large and complex banks could be resolved without some type of international treaty, but noted there is “very little appetite” for such a treaty.
- SPOE: Panelists supported the single point of entry strategy as being the best way to resolve large firms with cross-border operations
- Living Will Disclosure: Hoenig stated that all sections section of living wills should be publicly disclosed, unless the firms can explain why certain parts are proprietary, to allows the market to judge the strength of a firm and Congress to assess if bankruptcy will work.
- FSB Structure: FDIC Director Jeremiah Norton spoke against the structure of the Financial Stability Board, specifically with the makeup of representation that includes just three American regulators but twenty from Europe.
- Shadow Banking: IMF Deputy Director Ceyla Pazarbasioglu said shadow banking can be a good thing, and that risks must be balanced against its benefits. She advocated for the need to fill data gaps to make effective regulation.
- Executive Compensation: Jeremiah Norton supported TBTF executives having more incentives to look after long-term institutional stability through equity incentives. Arthur Wilmarth suggested that bail-in debt would give them “long-term skin in the game.”
Speakers
- Jeffery Lacker, President of the Federal Reserve Bank of Richmond
- Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation (FDIC)
- Simon Johnson, Professor at the Sloan School of Management, MIT and Senior Fellow at the Peterson Institute for International Economics
- Paul Tucker, Senior Fellow at Harvard School of Government and former Deputy Governor or the Bank of England
- Jim Wigand, Partner at Millstein & Co. and former Director of the FDIC’s Office of Complex Financial Institutions
- Jay Westbrook, Chair of Business Law at University of Texas at Austin School of Law
- Anat Admati, Professor of Finance at the Stanford Graduate School of Business
- Jeremiah Norton, Director, Federal Deposit Insurance Corporation
- Henry Hu, University of Texas School of Law
- John Parsons, Sloan School of Management, MIT
- Thomas Cooley, New York University
- Martin Hellwig, University of Bonn
- Ceyla Pazarbasioglu, Deputy Director, Monetary and Capital Markets Department, International Monetary Fund
- Zoltan Poszar, Senior Advisor, Office of Financial Research, Treasury Department
- Arthur Wilmarth, George Washington University School of Law
Keynote – Jeffery Lacker
Jeffery Lacker, President of the Federal Reserve Bank of Richmond, gave the first keynote address and stated that financial reforms have not ended the problem of “too big to fail” financial institutions. He said that fundamental problems stem from market participants expecting government support of stressed financial institutions and because politicians feel compelled to provide this support. He added that this perception of government intervention encourages fragility in the financial system and noted that there is ambiguity about the scope of any future government support.
Lacker stated that “strengthening regulatory restraints on risk-taking” are important measures to “reduce the likelihood of distress,” but that regulators “must realign the incentives of financial market participants” by removing expectations of government intervention. He stated that if firms and creditors do not expect government support, they will limit their risk taking, which would help avoid over-reliance on bank supervisors.
Lacker highlighted that bankruptcy for large financial institutions “offers many advantages” including collective proceedings and having costs ultimately borne on creditors and other stakeholders. He stated that proposed strategies to vest a firm’s losses at the parent company “might not be the most effective to restore market discipline” and that exemptions from termination stays for short-term financing instruments “arguably over-encourages” use of such instruments and “enhances the growth and fragility of shadow banking.”
He concluded that “credible commitment to orderly unassisted resolutions” may require eliminating the government’s ability to provide ad hoc rescues including “repealing the Federal Reserve’s remaining emergency lending powers and further restraining the Fed’s ability to lend to failing institutions.”
Question and Answer
An audience member asked if the Fed will stop characterizing derivatives as non-cash flow items. Lacker replied that treatment of derivatives is an “important and complicated topic” and said that safe harbor treatment under resolution processes “have gone too far” and “over-encourage” the use of derivatives over other arrangements.
Paul Tucker, former Deputy Director of the Bank of England, asked what the duties of the courts would be in a cross-border bankruptcy and how jurisdiction would be claimed on branches and subsidiaries. Lacker said that two possible paths can be pursued: 1) cooperation between countries on a “planetary view;” and 2) severability and compartmentalization of each jurisdiction. He said that whatever path is taken, a resolution in one jurisdiction should not prevent the operations of a subsidiary in another.
Another question asked what tools the FDIC will use if the next living will submissions are deemed “non-credible.” Lacker responded that the Fed gave a “fairly comprehensive” set of instructions to firms on what to improve in their submissions but said he does not think the regulatory community has “defined what is sufficient.” This, he said, is a “symptom” of “learning as we go.” He later added that the Fed will work to “enhance the visibility” of living wills through more public disclosure, so that creditors know how they will be treated in a bankruptcy.
When asked if the Fed’s 13.3 authority threatens to turn the central bank into a “market maker of last resort,” Lacker said that he is “skeptical of having the government second guess market prices.”
Another question asked how the Fed is preparing firms for interest rate risk. Lacker noted this preparation has been part of the Fed’s supervisory process for decades and that they assess firms under various scenarios.
When asked how funding a firm works during a bankruptcy, Lacker highlighted that firms have “built substantial liquidity buffers” and have reduced their reliance on short term funding. He added that regulators will “need to work backwards” from a situation where firms provide the liquidity themselves to where firms are now.
Session 1 – Will “Orderly Failure” Work for Large Complex Institutions
Simon Johnson, Professor at MIT, began the discussion by asking “where we stand now” in terms of the bankruptcy process and development of Dodd-Frank Title I.
Jay Westbrook, Chair of Business Law at the University of Texas at Austin School of Law, said that the government would have to fix the bankruptcy code as it currently stands to allow a large institution to use it, noting that the court system is “not nearly fast enough now.”
Jim Wigand, former Director of the Office of Complex Financial Institutions at the FDIC, said that the “vast majority” of holding companies could go through the bankruptcy and insolvency framework under Title I, but noted that a “handful of firms” could cause systemic problems.
Paul Tucker replied that it “verges on fantasy” to think that large and complex banks could be resolved without some type of international treaty, noting there is “very little appetite” for such a treaty and said regulators would need to ring fence entities in different legal jurisdictions.
Johnson then asked what types of actions are considered bailouts.
Wigand said there is a “continuum of support” action that can be considered a bailout, but that liquidity support “has not been viewed historically as a bailout.” He said liquidity allows for a more orderly process and said there needs to be “firewalls in the system” to protect taxpayers.
Tucker said it is essential that central banks do not lend to insolvent firms and said it is “strange” that Dodd-Frank provides for a line of credit from the Treasury in resolution processes. He then explained that the best resolution strategy would be for subsidiaries to issue equity and super-subordinated debt to their holding company and transfer their losses to the holding company so that the subsidiary does not default. He said if this strategy does not succeed “banks will have to be broken up.”
Westbrook said the strategy outlined by Tucker is similar to the “single point of entry” (SPOE) strategy and noted that “liquidity is the key.” He said that liquidity will have to come from a government agency if there is not enough at the firm to give confidence to the market.
Wigand stressed that the SPOE is a “strategic approach to resolution” and that it does not have to be applied under Title II, and explained that the strategy structurally subordinates creditors by creating a hierarchy outlining who will bear losses of the firm. He added that long term investors are better positioned to promote better incentives for the level of risk taking.
Question and Answer
An audience member asked who will be the ultimate holders of assets that “insure the entire system” during a systemic event. Tucker replied that he hoped to see part of this answer come out of the next G20 meeting in Brisbane and added that regulators “cannot allow banks and shadow banks” to ultimately hold these assets. This leaves insurance funds and mutual funds to hold those assets, he concluded, noting that these are ultimately owned by households. He also noted there is an “agency problem” for households when giving their money to these institutions. Wigand agreed that there is an agency issue involved with holding assets but explained that what matters is who holds the credit risk associated with the investment instruments. Johnson later added that if asset managers are ultimately the holder of these bonds, it may “bring into question” asset managers as systemically important financial institutions (SIFIs).
The next question asked how to avoid “pillaging of subsidiaries” during a resolution. Tucker replied that regulators of a subsidiary will ring fence the entities if they do not trust the regulator of the holding company and that this strategy will force regulators to face their beliefs and their trust of other authorities. Westbrook added that governments around the world need to take on the burden of being a host country.
Another audience member asked how much equity relative to “total loss absorbing capacity” (TLAC) should be held. Tucker said that even if equity requirements of Basel III are not the best solution there will still be discipline of the institutions from bond holders, adding that if investors do not want to hold these bonds, the banks will shrink. Wigand said that “calibration is critical” since equity holders can exercise a put option and sell their shares first.
When asked about derivatives transactions in resolution, Wigand noted that one objection to the SPOE is that derivatives contracts are held at the holding company level with hold company credit support. He said if the subsidiaries maintain continuity of operations then he hopes that counterparties do not have the ability to accelerate and terminate their contracts. Tucker agreed that these contracts need a freeze for resolution to be effective. He then noted that asset managers have not yet signed the ISDA early termination stay protocol and that dealers would be banned from dealing with them if they do not sign it.
Johnson asked the panel if “too big to fail” has been ended. Westbrook said “no;” Wigand said it is “not a question of too big but too connected” and that the “jury is still out” if firms are too connected to fail; and Tucker said that ending “too big to fail” is “absolutely within reach,” added that resolution regimes are better in Europe than in the U.S.
Next, Johnson asked what levels of TLAC should be required. Tucker replied that a level of 20-25 percent of risk weighted assets (RWA) comprised of equity and bonds will likely be required. He added that the Basel Committee is “on course to introduce floors on risk weights” and that he hopes the committee will also address calculation of total assets. Wigand agreed that the likely level will be 20-25 percent with the ability to calibrate.
Keynote – Thomas Hoenig
FDIC Vice Chairman Thomas Hoenig, in his keynote address, stated that the U.S. and global financial systems “are the definition of concentrated risk” because they are composed of institutions that are “highly leveraged, heavily reliant on wholesale funding, and unduly interconnected.”
Hoenig said that shortcomings in firms’ living will submissions “perpetuate uncertainties” around resolution, “negatively affect asset values, raise concerns of contagion, and exacerbate crisis.” He said as the FDIC and Fed work with firms to improve their resolution plans, “CEOs and directors must be fully engaged and confident in their ability to take their firms through bankruptcy.” He then highlighted the following as important issues moving forward: 1) capital; 2) liquidity; and 3) structure and cross-border challenges.
On capital, Hoenig stated that while “no amount of equity capital can save an individual firm from the consequences of poor management,” sufficient levels of equity enable managers to survive “errors in judgment.” He then stated that “firm and industry resilience is still sorely lacking.” He criticized RWA calculations saying they “permit firms literally to reduce the size of their balance sheets” and reduce levels of apparent leverage. He said a better calculation of risk is the Global Capital Index, which he developed, and noted that using this model, regional banks have “roughly double” the capital level that SIFIs do. He added that the “portion of the financial industry with the greatest concentration of assets is the least well prepared to absorb loss.”
On liquidity, Hoenig stated that in anticipating a bankruptcy a firm should “assume the worst” in a liquidity shock and outline how broker-dealer and other affiliates “will access sufficient unencumbered assets to provide debtor-in-possession financing.” He noted the early termination stays for derivatives and said that “more of this kind of work is needed” to mitigate the liquidity challenges and those similar actions may be needed “for those parts of the repo book that use long-term assets to secure short-term funding.”
On structure and cross-border challenges, Hoenig explained that complexities in corporate structure, including inter-dependencies and cross-border activities, influence whether a firm can be taken through bankruptcy and noted that thing such as depositor preference and contract enforceability differ in among various countries. One danger, he said, is that affiliates and branches could be subject to “sovereign ring fencing of local funds” which would tie up liquid assets when they are most needed. He added that this is “particularly relevant for broker-dealer activities where volatile wholesale funding is most vulnerable to runs across borders and institutions.”
Question and Answer
Simon Johnson asked how many chances banks will get to improve their living will submissions before the FDIC takes remedial actions. Hoenig responded by noting that the FDIC can increase supervision, raise capital requirements, and force divestures if plans are not credible, but added that the advantage of Title I is the opportunity to force a firm’s structure to be “more amenable to bankruptcy.”
Another question asked how the lender of last resort function of the Fed factors into the living will plans. Hoenig said that each firm is asked for the scenario of their “idiosyncratic failure” and thus assumes that they have no liquidity access.
When asked what sections of living wills should be transparent, Hoenig stated that all sections should be disclosed, unless the firms can explain why certain parts are proprietary. He said this transparency is important because it allows the market to judge the strength of a firm and allows Congress to say if bankruptcy will work.
An audience member asked why transaction tests are done at small banks but not larger banks. Hoenig said that transaction tests could be carried out systemically at large banks, adding that he is “not a fan of embedded examiners” and that having more statisticians and fewer econometricians would help in the examination process.
Session Two: Reducing the Fragility of the Financial System
Anat Admati of the Stanford Graduate School of Business moderated a discussion of fragility in the financial system. She said that the too big to fail (TBTF) firms generally have very little equity funding and rely instead on a variety of debt commitments, making them the most indebted institutions in the country. However, she said these structures are not “inevitably inherent,” but rather choices that the institutions have made. She stressed that Title I of Dodd-Frank “requires that we don’t live with this system” and that firms are “living unnecessarily dangerously.”
Admati said there is plenty of discussion on what to do when firms fail, but not enough about solving the reasons for their failure. She called limited disclosures of resolution plans a risk, and said the “biggest can of worms” is opacity in measurements.
John Parsons of the Sloan School of Management at MIT focused his comments on derivatives. He said the easiest part of Dodd-Frank was mandatory trade reporting of derivatives, but that the data being reported to the Commodity Futures Trading Commission (CFTC) is a “mess.” He was critical of the industry being reluctant to surrender data to the CFTC, and said their reporting is “like Swiss cheese” with significant details missing.
Speaking about both regulators and the industry, Parsons commented that “they’re not on top of this.” He called on the CFTC to stop publishing what said is “trash data” and said regulators should not have to assume the full burden of developing reporting conventions, but rather let the industry contribute as well. Parsons said that “as a culture,” we must demand that regulators cannot accept the notion that firm operations are too complex to report.
Henry Hu, University of Texas School of Law, agreed that more disclosures and enhancing public information would be beneficial, saying that “sunlight is a good thing.” He commented that people believe information asymmetry helped cause the crisis.
Hu credited the Federal Reserve for creating a new disclosure universe for TBTF banks. However, he said financial innovation creates new risks that are unclear and called the reporting tools of the new bank disclosures “incredibly crude.” He said intermediaries can have a hard time describing objective realities in such complex systems, and said the possibility of “simplifying reality” by breaking up banks should be researched.
Jeremiah Norton, Director of the FDIC, opened by highlighting regulator efforts to contain systemic risk through mechanisms such as leverage and liquidity ratios, central clearing of derivatives, and regulation of activities through the Volcker Rule, risk retention, and other others.
Norton, however, said these efforts are not enough and that regulators must “push the distance to default out further.” He said regulators must be able to resolve institutions through bankruptcy and stressed that Congress pushed for a way to make this a reality in Dodd-Frank. He lamented that seven years after the crisis, “we’re still not at the right place” and the pace of reform has been very slow.
Norton stated his concern that regulators are relying too much on the Basel process and measurements using risk-weighted assets. He said Basel’s capital requirements are too opaque and allow for instruments of questionable liquidity in times of stress to be counted as capital on par with equity. Norton was also critical of the Financial Stability Board (FSB) for comprising only three representatives from the United States but twenty from Europe despite the fact that Europe now has a single supervisory banking mechanism. He questioned how policy decisions are made with that composition of representation, and commented that the three U.S. representatives “don’t always get along.”
Commenting on TBTF firm executives, Norton stated that they run their institutions without thinking of themselves as long-term owners, and advocated for the need to have them think across economic cycles. He said executives have better responses when equity gives them incentives to think about long-term stability.
Session Three: Industry Structure and the Shadow Banking System
Thomas Cooley, Professor of Economics at New York University, moderated a discussion of industry structure and shadow banking, which he said is very important to the financial system but exists because of regulatory arbitrage.
Martin Hellwig, Professor of Economics at the University of Bonn, said that when thinking about industry structure, the key questions to ask are about the proper structure of governance for the allocation of excess funds, and whether structural reform should be used to make resolution easier. He commented that the industry and its major institutions have grown because of mercantilist policies, the rise of national champions, significant excess capacity, the growth of derivatives, and the increase in inter-institution business. He also stated his belief that the derivatives industry is “inherently unstable.”
Ceyla Pazarbasioglu, Deputy Director of the International Monetary Fund’s (IMF) Monetary and Capital Markets Department, said the FSB had made efforts to deal with the shadow banking sector since 2011, but commented that the development of shadow banking, or non-bank credit intermediation, can be a positive development. She said there is a need for a system to provide credit when banks are unable, but that leverage in the banking system can then migrate to shadow banking.
Pazarbasioglu said shadow banking is very complex and involves so many steps that regulations targeting individual steps are ineffective. She said regulators must work to contain risks while preserving the “good parts” of shadow banking, but the greatest challenge is the form of data gaps. More information is needed, she said, to effectively act on shadow banking.
Asked about regulators’ approach to asset managers, Pazarbasioglu said asset managers do face liquidity risk and suggested that they should be subject to exposure limits. She questioned whether asset managers should be allowed to be too concentrated in a single type of instrument.
Zoltan Poszar, Senior Advisor in the Office of Financial Research, said shadow banking is no longer just the result of regulatory arbitrage. He said the sector exists because of market conditions that have created a demand for wholesale funding and safe short-term investments for cash investors such as FX reserve managers, corporations, and asset managers. He said repurchase agreements and money market funds in the shadow banking sector are a natural place for market participants to go when there are not enough Treasury bills and they cannot put large amounts of money into uninsured bank accounts. Poszar stressed that there can be no solutions to the risks of shadow banking without first understanding the ecosystem in which it exists.
Asked whether there is something fundamental about shadow banking activities that could not take place in regulated sectors, Poszar said the traditional banking system would be unable to fill the gap for some of these asset demands, but that the public sector could be an alternative with the issuance of more Treasury bills or the Federal Reserve’s use of its large balance sheet and reverse repos.
Arthur Wilmarth, Professor of Law at George Washington University’s School of Law, said shadow banking provides different types of funding for the largest institutions, and was very critical of regulatory efforts thus far to combat systemic risk. He said money market fund reform “has been a fiasco,” and that securitization reform has been hurt by the Qualified Mortgage and Qualified Residential Mortgage rules that let banks bundle up mortgages with no down payments. He added that the industry has successfully pushed back on derivatives action despite lots of regulator activity, and that the SPOE approach protects shadow banking mechanisms.
Wilmarth suggested that SIFI executive’s compensation should include significant bail-in debt that they cannot sell to give them “long-term skin in the game incentives” to promote firms’ long-term stability.
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