MIT Golub Center for Finance and Policy
Public Policy
Repealing Title II of Dodd-Frank
By
The Misguided Proposal to Repeal Title II of Dodd-Frank
By Daniel K. Tarullo
On April 21, President Trump published a memo to Treasury Secretary Mnuchin instructing him to conduct a review of the Orderly Liquidation Authority for systemically important financial institutions created by Title II of the Dodd-Frank Act.1 The memo is careful not to dictate the outcome of that review. Indeed, the somewhat unusual formal, public character of an instruction from the President to one of his cabinet members may have been intended in part to avoid a Congressional rush to judgment on the question of whether Title II should be repealed.2 Whatever its intent, though, the memorandum rehearses the arguments lodged against Title II and thus lends the debate more prominence. It is important to understand why, at least for the foreseeable future, repeal of Title II would increase both risks to financial stability and, in all likelihood, the too-big-to-fail problem.
Importance of Credible Resolution Mechanisms for Addressing Too-Big-to-Fail
The too-big-to-fail problem is by definition one in which government authorities are tempted to inject public capital into, or subsidize another firm’s purchase of, a large failing financial institution because they fear its insolvency would wreak havoc on the financial system. Governments worry not only that the failure of a large, interconnected bank will impose direct losses on a wide range of counterparties, investors, and clients. They also fear that the failure of such a firm might cause those groups to run from other large banks that might be exposed to the same risks that are bringing down the first firm.
The prospect of government support signals to creditors that they may not suffer losses even if the bank becomes insolvent. As a result, the bank may benefit from lower funding costs than would otherwise be borne given the risks associated with the firm. This form of moral hazard was exemplified in the multiple notches of credit “uplift” assigned by ratings agencies to the largest banks before the financial crisis.
The much stronger capital requirements and other forms of regulation adopted since the crisis have substantially reduced the probability that any of the largest U.S. banks will fail. But they have not and, realistically, cannot totally eliminate the possibility of idiosyncratic or systemically-driven failures. Short of a radical break-up of banks of substantial systemic importance, the possibility remains of a failure that shatters confidence in the financial system.3 A credible resolution option is thus central to countering the TBTF problem. Such an option would be one in which both government officials and markets believed that a major financial firm could be resolved so as to impose losses on shareholders and creditors, without major disruption to the financial system or the necessity for direct or indirect government support.
There is a long history of governments faced with the possibility of a cascading financial crisis erring on the side of extraordinary support for large financial firms. This pattern can be found across countries and across governments with very different ideological leanings. During 2008 governments around the world took a range of actions to save systemically important firms. In the United States, government authorities arranged and, in one way or another, subsidized the acquisitions by other banks of Bears Stearns, Wachovia Bank, and Merrill Lynch. The fear of financial meltdown then led to the direct government bailouts of AIG, Fannie Mae, and Freddie Mac. And, as evidence that these fears were not misplaced, it was the bankruptcy of Lehman Brothers after the frantic, unsuccessful efforts of U.S. authorities to arrange its sale that precipitated the most acute phase of the financial crisis. Congressional passage of the Troubled Assets Relief Program (TARP) followed the Lehman failure. Treasury used TARP to inject public capital into all the nation’s largest banks in an ultimately successful effort to stabilize the financial system. As with most government rescues of failing firms, all creditors were protected—big and small, long-term and short-term.
Creating a Credible Resolution Regime
This history, on top of many prior experiences around the world, cautions that we should not underestimate the challenge in convincing markets that government authorities really will contemplate failure of a major financial firm – particularly in a period of generalized financial stress. There are really no good examples of systemically significant firms being resolved in a non-disorderly way.
This challenge argues for a multi-pronged approach to developing credible resolution options. One prong was the orderly liquidation authority enacted into law as Title II of Dodd-Frank. The second prong would be amendment of the Bankruptcy Code to take account of the peculiarities of financial firms. The third prong is the resolution planning process required by Dodd-Frank for larger banks. Because of current debates over repeal of Title II, I will give more attention to that first prong, though this allocation of space is not meant to reflect on the significance of the other two.
Orderly Liquidation Authority. Title II of Dodd-Frank creates a special resolution mechanism that is analogous to the resolution authority the FDIC has over insured depository institutions. Under Title II, the FDIC can be placed in the position of receiver and liquidator of a financial firm whose failure could have a serious adverse effect on financial stability – as determined by the Treasury, the Federal Reserve and the FDIC itself. Title II takes account of three peculiarities of financial firms that need to be addressed to achieve orderly resolutions, the absence of which rendered bankruptcy law an ineffective instrument for resolving large financial firms in an orderly fashion during the crisis.
First, Title II allows the FDIC to move quickly, so as to maintain continuity of operations and to avoid actions (such as asset fire sales) that could pose a risk to the financial system as a whole. The very nature of financial markets—and of the larger firms operating in those markets—means that they are susceptible to a sudden loss of market confidence. Many customers and counterparties of banking firms can, if they have doubts that the firm will continue to function, pull away in a manner that is much faster and more damaging than customers and suppliers of most non-financial firms. A rapid counterparty retreat can shift a firm from viable to non-viable in quite a short period of time. This is what produces disorder.
Second, Title II provides a source of immediate funding if it is necessary to continue the relationships to which I have just referred. The Bankruptcy Code allows for so-called debtor-in-possession (DIP) financing for any firm in bankruptcy – something often essential to maximize the value of the firm for creditors. The line of credit available from Treasury to the FDIC under Title II is really just pre-arranged DIP financing. Again, because of the nature of financial firms and the markets in which they operate, a banking firm may need funding more quickly and in much larger amounts than a non-financial firm.
Third, Title II provides for a limited stay of close-out rights of qualified financial contract (QFC) counterparties and the ability to rapidly reorganize a failed firm’s assets. The failure of one entity within a large financial firm could trigger large-scale terminations of QFCs, as counterparties exercise their contractual rights to terminate and close-out the contracts. Subject to important creditor safeguards, the FDIC can blunt the disruptive, uncertainty-driven race to seize and liquidate a firm’s assets upon its entrance into resolution by holding in place contracts that preserve the firm’s critical operations.
Proposals to repeal the orderly liquidation authority of Title II seem motivated by two main objections. First, there is concern that it provides fewer safeguards for the rights of individual creditors than does the Bankruptcy Code. Second, proponents of repeal regard the availability of short-term funding under Title II as a form of subsidy that fosters moral hazard. Both of the norms underlying these concerns are entirely legitimate, but in this context neither warrants repeal of Title II.
The protections afforded creditors under Title II closely resemble those provided for the creditors of failed insured depository institutions resolved by the FDIC under its longstanding authorities. While it is true that the Bankruptcy Code contains a more specified set of protections for creditors to voice their interests, it is unclear how wide the difference in actual protection may be. As others have noted, despite certain deviations that prioritize the FDIC’s discretion to act to promote market stability, Title II remains largely consistent with the fundamental principles of bankruptcy law.4 In addition to the FDIC’s duty to take actions necessary to promote financial stability, Title II also imposes an obligation on the receiver to seek to maximize the value of the firm’s assets. Under the FDIC’s favored approach to orderly resolution—single point of entry— losses are imposed on the shareholders and creditors of the parent holding company, while using the parent holding company’s capital and liquidity resources to shore up its operating subsidiaries. A successful single point of entry resolution would avoid a disorderly and disruptive wind-down of a failed firm as well as mitigate the losses ultimately borne by holding company’s creditors.5
A specific concern in the Title II context is that creditors of a holding company may suffer from the FDIC’s single point of entry approach because the use of holding company resources to restore operating subsidiaries would mean that not all available resources are being used to directly compensate the holding company’s creditors. That is, indeed, possible. But creditors of the holding company are now on notice of the FDIC’s plans and the particular resolution plans of the firms themselves. And the Federal Reserve has required the largest banks to keep their holding companies essentially “clean” (i.e., non-operational) and to identify longer-term debt available for conversion to equity in resolution that should that be necessary to absorb losses. Thus any holding company creditors are now on full notice of the possibility that their debts will not be paid in full even where an operating subsidiary may remain solvent. The potential for losses to these creditors is not only fair; it should also increase market discipline on the large holding companies issuing the debt.
As to the availability to the FDIC of a line of credit from Treasury to use as necessary to help fund a firm that has entered the orderly liquidation process – as already noted, that kind of funding seems analogous to the DIP financing that is frequently arranged for firms in bankruptcy. The difference, of course, is that DIP financing is customarily arranged with private creditors and for amounts well below the largest of such arrangements.6 But unlike most firms, which would have no need for such a considerable credit line, large financial firms are usually reliant on some short-term funding, which if withdrawn quickly by anxious counterparties can force the firm into fire sales of assets. For some of the same reasons that prompt investors and counterparties to pull back in periods of stress, there simply may not be time or market capacity to arrange private credit before a financial firm is placed into the Title II process.
So is there any arguable moral hazard created by Title II, and thus any arguable increase in short-term funding? One would have to say there is at the margin, insofar as it is a particular group of creditors that — ex ante — has reason to believe it may be fully repaid. Of course, short-term funders are not in the business of taking many risks in the first place. That’s why they preserve their option to run so quickly, and that’s what the availability of a line of credit protects against. So the incremental moral hazard created here is pretty small. After all, these funders are by assumption able to run. The whole point is to keep them from doing so. Indeed, the very assurance that this funding is available might reduce the incentive of short-term funders to run in the first place.
Moreover, there is little chance that taxpayers would end up footing any of the bill that the FDIC’s funding might create. The FDIC has priority for repayment. The post-crisis liquidity requirements, along with the measures taken as part of the resolution planning process, should limit the amount of short-term funding that is needed from external sources. And, because of the Federal Reserve’s requirement that the largest financial firms hold substantial amounts of longer-term debt that can be converted into equity in resolution, there will be other creditors to absorb any losses that might occur.
The possible modest costs to creditor protection and moral hazard safeguards associated with Title II are more than outweighed by the prospect of not having a credible resolution mechanism for systemically important financial firms. Precisely because of the rapid flight of funding and asset fire sales that might ensue, government authorities would be more tempted to find some way to assist the shaky firm – thus increasing, rather than reducing, the potential for moral hazard. Moreover, the important aim of containing reliance on short-term funding at large banking organizations is being pursued through liquidity regulation and through the resolution planning process discussed below.
Another consideration is that, at least under current bankruptcy law, the United States government would have no basis for the joint resolution preparations in which it has been engaging with key foreign authorities, since the Federal Reserve, Treasury, and FDIC would have no role in what would be the only recourse available – a bankruptcy filing. Without the assurances that come from such planning – including the confidence that government authorities will build on past cooperation to handle unanticipated problems in a resolution — host jurisdictions may move towards more or less complete ring-fencing of U.S. bank operations in their countries.
Amending the Bankruptcy Code. The second prong of a resolution strategy is the Bankruptcy Code. At present, the Code does not take into account the peculiarities of financial firms. As I have explained elsewhere,7 it makes great sense to amend the Bankruptcy Code in ways that do just that.8 These changes would make the Bankruptcy Code a more workable mechanism for resolving all but the most systemically important firms. Along with the measures firms are taking in order to comply with the Dodd-Frank resolution planning process and the Federal Reserve’s requirements for minimum amounts of longer-term debt that could be converted to equity, amendments to the Code could also provide a viable alternative to Title II even for the most systemically important firms. This outcome could realize the full traditional panoply of creditor protections under bankruptcy law while still preserving financial stability.
However, it is important to evaluate various Bankruptcy Code amendment proposals on their individual merits to be sure that they both remedied the current elements of the Bankruptcy Code that are ill-suited to deal with large financial firms and that they in fact preserve the fairness and due process strengths of bankruptcy adjudications. For example, proposals that do not address the funding issues discussed earlier cannot really be said to create a credible resolution mechanism, at least absent dramatic changes to the funding practices of large financial firms. There would be too high a risk that short-term funders and other counterparties run in the face of uncertainty about the ability of the insolvent firm to repay short-term liabilities.
The Resolution Planning Process. The third prong of a resolution strategy is the resolution planning process created by Section 165(d) of Dodd-Frank. This provision requires larger banks to submit regular plans for their rapid and orderly resolution in the event of material distress or insolvency. The Federal Reserve and FDIC can, after reviewing these plans, require additional work. The statute also allows the two agencies to impose additional prudential safeguards or even divestitures in the event that a bank does not correct deficiencies in its plan.
The different (though complementary) perspectives of the two agencies, along with the sheer novelty of the task, meant that it took them a while to outline for themselves and the banks the elements and characteristics of a useful resolution plan. There was something to the complaints by banks in the early stages that the agencies were not providing adequate guidance. But over the last two years or so I believe they have done just that.
As revealed in their deficiency determinations last year, the agencies are focused on making the firms more resolvable by ensuring that their normal-time operations are consistent with a viable resolution strategy, rather than on the creation of a detailed how-to manual that would probably remain on the shelf during a “resolution weekend.” To be sure, it is important that certain procedures for firm management and boards to cope with stress situations be worked out in advance and actually followed should the need arise. But most of the work lies in making certain that the firms could be broken up in resolution if required, that liquidity would be available in the immediate aftermath of insolvency, and that contractual arrangements with counterparties or service providers would not entangle a resolution authority in a hopeless maze of immediate claims.
Some banks have complained because the resolution planning process is forcing some changes in how the largest banks operate in normal times. Yet that is precisely the point of the whole exercise and, in fact, the key imperative in a credible resolution planning process. The changes made to date following Federal Reserve and FDIC reviews of the plans will be helpful for facilitating orderly resolution under either Title II or the Bankruptcy Code. It is true that some of the changes in bank operations needed to develop this system may not be cost-minimizing during normal times. But here, as elsewhere in thinking about financial regulation, the focus should be on activity that is sustainable over time and consistent with combatting the TBTF problem, not simply on maximizing near-term activity or profits.
A good bit of work remains to be done in the next couple of years, especially in integrating resolution considerations into ongoing firm practices and policies, so that recent improvements are not undone as firms change over time. The agencies must not relax their expectations for the firms or their willingness to impose extra capital or liquidity requirements, or to require structural changes, should a banking organization be unable to remediate deficiencies in its plan.
Conclusion
With continued progress in the resolution planning process, and with well-crafted amendments, the Bankruptcy Code may eventually be a credible and presumptive mechanism for resolving even the largest financial firms. But we are a good ways from that point today. Should this goal be reached, it would still be ill-advised to repeal Title II. Given the untested nature of any instrument for resolving very large financial firms, why jettison another option for a third way between bailout and disorderly failure, at least until an amended Bankruptcy Code had been successfully applied? In the absence of adequate changes to the Bankruptcy Code, repealing Title II would simply be dangerous. The potential for Lehman-like failures would increase, moral hazard would strengthen, and a future government would be more likely to have to scramble to find new ways of helping a large failing firm.
Notes
[1] Presidential Memorandum for the Secretary of the Treasury, April 21, 2017. https://www.whitehouse.gov/the-press-office/2017/04/21/presidential-memorandum-secretary-treasury-0 .
[2] Because Title II has been scored as having budgetary implications, it may be subject to repeal as part of the Congressional budget reconciliation process, during which only simple majorities are needed for action. Thus, there would not be need to marshal 60 votes to overcome a filibuster in the Senate, which could be used during a normal legislative process.
[3] The experience with Wachovia in 2008 suggests that the failure of even a very large regional bank with only limited capital markets activities might be thought to endanger the financial system in some circumstances. This experience argues for at least some resolution planning in such firms and for further development of the resolution options discussed below.
[4] Baird, Douglas G. and Morrison, Edward R., Dodd-Frank for Bankruptcy Lawyers (July 25, 2011). Columbia Law and Economics Working Paper No. 401. Available at SSRN: https://ssrn.com/abstract=1895692 or http://dx.doi.org/10.2139/ssrn.1895692.
[5] A multiple point-of-entry approach is also possible, by which each subsidiary is separately resolved. However, it appears most appropriate for banking organizations composed solely or dominantly of separately chartered and capitalized commercial banks.
[6] For example, the largest private sector DIP facility was roughly $10 billion (Calpine Corporation, January 2007) as compared to the government facilities for AIG (approximately, $180 billion) and GM (approximately, $33 billion).
[7] For a more detailed discussion, see Daniel K. Tarullo (2013), “Toward Building a More Effective Resolution Regime: Progress and Challenges,” speech delivered at “Planning for the Orderly Resolution of a Global Systemically Important Bank,” a conference sponsored by the Federal Reserve Board and the Federal Reserve Bank of Richmond, Washington, October 18.
[8] See, e.g., Thomas H. Jackson (2015), Building on Bankruptcy: A Revised Chapter 14 Proposal for the Recapitalization, Reorganization, or Liquidation of Large Financial Institutions, ch. 2 in Kenneth Scott, Thomas Jackson, and John Taylor, eds., Making Failure Feasible, Hoover Institution, Stanford University; John Bovenzi, Randall Guynn, and Thomas Jackson (2013), “Too Big to Fail: The Path to a Solution,” Bipartisan Policy Center, Washington, D.C.
Daniel Tarullo was a member of the Board of Governors of the Federal Reserve System from January 2009 to April 2017. He served as Chairman of the Board’s Committee on Supervision and Regulation, Chairman of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation, and Chairman of the Federal Financial Institutions Examination Council. Mr. Tarullo was in residence at the Golub Center for Finance and Policy as a Visiting Distinguished Fellow shortly after leaving the Fed.
