What Should the Recovery, Resolution and Crisis Management Processes Be? John F. Bovenzi June 16, 2016

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1 What Should the Recovery, Resolution and Crisis Management Processes Be? John F. Bovenzi June 16, 2016 I have been asked to speak about the recovery, resolution and crisis management processes from the point of view of a bank regulator. To do this I will focus on my experiences in the US where I served for over 20 years in senior level positions at the FDIC, where much of my responsibility was focused on handling problem and failing banks. First, what is it we seek to accomplish? I believe the objectives are for bank regulators to have robust processes in place to take progressively stronger actions to correct problem bank situations and, should those fail, to be able to close any bank that becomes insolvent in a timely manner without creating a risk of loss to taxpayers and without creating unacceptable spillover effects to the broader financial and economic systems. These goals are not easily accomplished. In the past several decades, many banks have failed, and when they do, bailouts have been the rule, not the exception. Private-sector losses, other than the capital at insolvent small banks, have been rare. As for large banks, few people ever wanted to talk about the possibility of imposing losses on large-bank creditors. The prevailing view seemed to be that too big to fail would always exist, so why even try to fix the problem. Many held the view it would scare the public if we even started talking about effectively addressing large-bank failures, so let s just accept 1

2 the fact that during financial crises bailouts will remain inevitable. As a result of this type of thinking, no real progress was made in ending too big to fail (TBTF) in the 25 years following the rescue of Continental Illinois in the US. Now, views have changed. An enormous amount of intellectual firepower is being devoted toward ending too big to fail. As a result significant progress, which will be discussed, has been made and the momentum is in the right direction. There is no reason we have to continue to accept bailouts as inevitable. I d like to briefly cover seven points today, each of which I consider to be important if we are to have effective recovery, resolution and crisis management processes. These are: 1. The need for bank regulators to take a long-term perspective; 2. The importance of having a framework in place for regulators to take prompt corrective action; 3. Creating a legislative framework and advanced planning for handling bank resolutions; 4. Developing effective resolution strategies; 5. Educating the public; 6. Empowering a lender of last resort, and 7. Ensuring the bank regulatory system has effective checks and balances (1) The first point is that bank regulators need to take a longterm perspective in determining and maintaining appropriate capital, liquidity and testing standards. This isn t easy. Often short-term agendas prevail. There is pressure from many stakeholders to reduce supervisory standards when times are good and to only strengthen them in the aftermath of a crisis. This creates a pendulum effect that 2

3 only serves to exacerbate credit booms and busts. The mid s to the mid-2000 s were a period of economic prosperity and relatively few bank failures in the US. It also was a period when bank capital and supervisory standards were weakened substantially. We paid the price for that short-sightedness during the 2008 financial crisis. Post crisis there has been a large and appropriate increase in capital and liquidity requirements at the largest banking organizations in the US. This helps in two important respects. First, the probability of failure for individual institutions is reduced. Second, the likelihood there will be a chain reaction of large-bank failures at the same time also is reduced. While both points are important, I d like to expand a little on the second, perhaps less obvious, point. It s generally been accepted that if one large bank fails, there likely will be multiple large bank failures, and if multiple large banks fail it s far more likely policymakers will resort to taxpayer bailouts. Thus, we need to reduce the likelihood that one large bank failure inevitably leads to additional failures, a chain reaction that only ends when we capitulate and bail everyone out. The Federal Reserve s annual stress tests now show that all of the large banks in the US have far more than enough capital to survive an economic disaster on par with our most recent financial crisis. In fact, even after such a scenario, the largest US banks still would have as much capital as the entire industry had in This suggests it would take some combination of a severe economic downturn plus a significant idiosyncratic event or events for an individual large bank to fail. This isn t to say it 3

4 can t or won t ever happen. At some point it almost certainly will. Every banking organization may face a severe economic downturn at the same time, which is a good part of the reason why multiple banks fail at the same time. However, if there is far more than enough capital in our largest banks to survive such an economic scenario, then an adverse idiosyncratic event also will be needed to cause the failure of a large bank. By definition the odds are much less that multiple large banks will experience a significant and adverse idiosyncratic event at the same time. Thus, the post-crisis increase in bank capital and liquidity is an important step toward substantially reducing the likelihood that one large bank failure inevitably will lead to multiple large bank failures and taxpayer bailouts. The robust and regular stress tests conducted by the Federal Reserve also are important. They are ensuring that capital levels remain strong. Let s hope that as crisis memories fade these supervisory standards can be maintained. (2) The second point is that there needs to be a legislative or regulatory framework for recovery management. Bank regulators must take progressively stronger supervisory actions as bank capital and liquidity weakens. Having standards for prompt corrective actions will help ensure that regulators don t wait too long to take enforcement actions. It does little good to put strong supervisory standards in place if no enforcement actions are taken to address shortfalls that arise when a bank s financial condition weakens. During the savings-and-loan crisis in the US during the 1980s, we saw what happens if regulators allow banks to operate with little to no capital. With little to lose many S&Ls took extravagant risks 4

5 that resulted in substantially higher losses than what would have occurred if earlier regulatory actions had been taken. An important part of taking prompt corrective action is closing insolvent banks in a timely manner. If effective triggers are not in place to ensure timely closings there often is a tendency to wait too long in hopeless situations, increasing the losses to creditors, deposit insurance funds and perhaps, taxpayers. (3) The third point is that there needs to be an effective legislative framework and advanced planning for handling bank resolutions. One positive development post crisis in the US was legislation providing a framework for handling the resolution of large banking organizations and the requirement that these banking organizations develop credible living wills. Prior to the 2008 financial crisis, there was little to no advanced planning on how to handle the failure of a large investment bank or an insurance company. Nor was there a viable framework through which to handle the resolution of such firms. When the crisis came the Federal Reserve and the Treasury had to improvise. They did an exceptional job under the circumstances, but obviously a better framework and more advanced planning was needed going forward. Title I of the 2010 Dodd-Frank Act requires that Systemically Important Financial Institutions (SIFIs) develop credible living wills, showing how they would be resolvable under the bankruptcy code. As someone who ran an FDIC-owned bridge bank during the financial crisis, without having the benefit of much in the way of advanced planning, I know the value of credible living wills. Initially these plans were judged on their informational completeness. Now they are being judged on their credibility. 5

6 Recently five of eight large-bank plans were deemed to be noncredible by the FDIC and the Federal Reserve. None of the eight were deemed credible. Rather than highlighting the inevitability of TBTF, these non-credible verdicts highlight the growing rigor of the living will process. The banks 2016 submissions will need to correct their deficiencies. The 2017 plans will need to adequately address their identified shortcomings. The intent is that by mid-2017 all eight of the banks be resolvable under the bankruptcy code. If the banks haven t corrected their deficiencies and shortcomings by mid-2017 the FDIC and the Federal Reserve have the authority to impose significant changes on a case-bycase basis. These changes could require increased capital, liquidity and divestiture of certain activities among other remedies. The living will process is beginning to have an impact. The structure of the US largest financial firms is beginning to change. - Banks are moving critical shared services into service companies and creating service-level agreements for key interaffiliate services. - Some firms are shrinking. - Most are reducing their operational complexity, better aligning their business operations with their legal entities. - Large banks are increasing and better positioning their capital, long-term debt and liquidity to be better prepared in the event of insolvency. While the living will process remains a work in progress, the pressure for credibility and the pace of change is accelerating. 6

7 Title II of Dodd-Frank created a framework for resolving large complex financial organizations by granting the FDIC similar authorities to what it has for resolving individual failed banks. In particular, the legislation granted the FDIC authority to create bridge financial companies, gain access to a source of liquidity (the orderly liquidation fund), and prevent domestic counterparties from canceling their qualified financial contracts (QFCs) in the event of insolvency. The authority to create bridge financial companies provides a vehicle through which the FDIC can maintain a firm s critical operations throughout the resolution period. The authority for automatic stays prevents domestic counterparties from cancelling financial contracts and selling collateral at fire sale prices, similar to what happened with Lehman Brothers. The orderly liquidation fund ensures there will be a source of liquidity to calm bank runs. (4) The fourth point is that effective resolution strategies need to be developed; strategies that protect taxpayers from losses, while keeping critical businesses open and operational. The development of the Single Point of Entry (SPOE) resolution strategy with bail-in-able capital is an example of such a strategy. The SPOE strategy provides a vehicle through which a SIFI s most important legal entities can remain open and operational in the event of insolvency. Only the parent holding company has to be closed. The SPOE strategy also materially reduces the challenges posed by cross-border activities. The ring fencing of assets becomes less likely if only the parent company fails and all other entities remain open and operational. 7

8 In addition, if regulators require banks to hold sufficient amounts of bail-in-able debt, taxpayers will be protected from losses and private-sector money will be available to recapitalize the banking organization should it enter resolution. Bail-in-able debt is the term used to describe long-term, subordinated debt that can be converted to capital in the event of insolvency. The requirement that banks hold more long-term debt flies in the face of historical practice. Banks borrow short-term money, namely deposits, in order to lend long-term money. However, with these significant maturity mismatches in our financial sector we have had too much of a good thing. The downside is that short-term creditors can run, which can wipe out much of the economic gain created by bank lending. Federal deposit insurance protects insured depositors, restraining the desire to run, but that leaves uninsured depositors and other short-term creditors still susceptible to runs. While long-term debt is more expensive than short-term debt, its advantage is that it cannot run. If it is contractually subordinate to other bank liabilities then taxpayers will be off the hook as the subordinated debt will be available to cover losses once capital is depleted. If the long-term debt is structured so it converts to equity upon a bank s resolution then it also can be used to recapitalize the bank. Importantly, with sufficient subordinated long-term debt, short-term creditors need not be exposed to losses, thus they need not run. The Federal Reserve has proposed rulemaking that will require that Global SIFIs headquartered in the US maintain substantial amounts of long-term debt or total loss absorbing capital 8

9 (TLAC) at the holding company level. Those funds have to be structured in a way that allows them to absorb losses (protecting taxpayers) and recapitalize a firm s material operating entities should one or more of them become insolvent. The ability to, in effect, upstream losses to the holding company and put the holding company into insolvency proceedings rather than the operating subsidiaries is what will allow the SPOE resolution strategy to work effectively. While the rulemaking is not yet complete, through the living will process the FDIC and the Federal Reserve already are requiring that firms hold sufficient levels of long-term debt to protect taxpayers. They also are requiring firms to place, or preposition, large amounts of long-term debt within each material operating entity to ensure its availability within that entity if needed. For foreign banking organizations the TLAC requirements are likely to be extended to domestic intermediate holding companies and their material operating entities, which will ensure that US taxpayers will be protected from losses at a foreign banking company s US operations. This substantially reduces the likelihood that ring fencing of assets by foreign jurisdictions will pose a burden on US taxpayers. Finalizing the Federal Reserve s long-term debt rule is a necessary step in protecting US taxpayers from future bailouts. (5) The fifth point is that bank regulators need to provide clarity and transparency into their bank resolution methods. They need to educate the public. If we are going to end TBTF, the market and the public need to understand what is going on. 9

10 This will be difficult, since it s not in the nature of bank regulators to be clear and transparent. The market will help self-regulate and protect taxpayers from bailouts if it understands what to expect. Long-term subordinated debt holders need to know they are at risk. This will help them price long-term debt appropriately. That will force large banks to reduce their size, complexity and and/or opacity in order to make their bail-in-able debt more affordable. This will be a positive development better allowing market forces to determine the structure of our banking industry. Conversely, and critically important, short-term creditors need to understand that under such a scenario they are not at risk. This will help prevent bank runs and spillover effects at other financial institutions. Greater transparency also will allow short-term debt to be priced appropriately. In this case it will allow banks to maintain low rates on relatively risk-free assets. (6) The sixth point is that banks need an effective lender of last resort. To determine when the government should step in to lend to banks requires that a clear distinction be made between capital and liquidity. Bailouts occur when the federal government provides money to cover a bank s capital losses. Even if the money is repaid it doesn t change the fact that taxpayers were put at risk and shareholders and other private sector creditors were bailed out. However, it is not a bailout if the government provides liquidity to a solvent bank. This is a traditional lender of last resort function that is widely recognized as a critical part of any financial system if it is to operate effectively. To protect 10

11 itself the lender of last resort should only provide fully collateralized loans to solvent banks, for short periods of time, at above market interest rates. Despite all of the measures discussed thus far, runs may still occur on occasion at solvent banks. A lender of last resort is needed to provide a backstop to protect solvent institutions when runs still occur and when market liquidity isn t available. (7) The seventh point and final point is that there should be checks and balances in the bank regulatory system. Checks and balances are necessary within and among bank regulators. These agencies hold a vast amount of power and responsibility. As a Chief Operating Officer at the FDIC I did not always welcome these checks and balances. I did not want to be subject to layers of coordination, review, oversight and second-guessing. I know many others have felt the same way. In retrospect it is clear that these checks and balances are critically important. No one has all the answers; some level of oversight and healthy tension and debate between decisionmakers leads to better results. Thank you. 11

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