New Report Points the Way Toward the End of Too-Big-to-Fail

Yesterday, BPC’s Financial Regulatory Reform Initiative (FRRI) released the first of its white papers analyzing whether the Dodd-Frank Act is working. The paper, titled Too Big to Fail: The Path to a Solution, was written by the co-chairs of the FRRI’s Failure Resolution Task Force: John Bovenzi, Randall D. Guynn, and Thomas H. Jackson. The BPC hosted a conversation on the paper at the National Press Club, moderated by FRRI Co-Chair Phillip Swagel. The event brought together people from all sides, and featured a robust conversation which can be seen here.

The paper’s main finding is that there has been a breakthrough in how to handle a systemically important financial institution (SIFI) that is failing. The breakthrough came as a result of the FDIC’s innovative decision to create a Single Point of Entry (SPOE) regime to deal with failing SIFIs. However, despite this breakthrough more needs to be done, particularly to better align this new system with the Bankruptcy Code. The paper contains a series of recommendations on how to do just this. If those recommendations are adopted, we will have tackled a key part of the ‘too-big-to-fail’ problem by solving the problem of how ‘to fail’ a large, complex SIFI without causing a financial crisis or panic.

The authors remarked that taxpayer funded bailouts of systemically important financial institutions (SIFIs) have been chosen by policymakers when the only alternative was to risk the collapse of the financial system. The report presents a third option where losses are absorbed by the private sector instead of by taxpayers. The SPOE strategy would also prevent the kind of contagious panics that can lead to the failure of multiple institutions.

While the report makes a series of recommendations to improve the current process, it presents four key points to ensure a successful failure resolution system:

1. Sufficient loss-absorbing capacity: SIFIs must hold enough long-term capital and equity to be able to absorb any losses that may come about from failure, to ensure short-term creditors don’t have the incentive to pull their money and cause a panic.
2. Bankruptcy Code: The legal tools must exist to promptly access this loss-absorbing capacity and effect the recapitalization of their businesses.
3. Structural or legal subordination: It must be clear to the public that loss-absorbing equity and debt will be treated as subordinate to other claims against the bankrupt company. Doing so allows the market to efficiently price different kinds of stakes in these firms.
4. Secured liquidity facility: Even after the healthy parts of a firm are recapitalized under SPOE, it may not be able to access capital right away. To ensure the firm can continue in the interim, it must have access to temporary liquidity from a private or public facility. The temporary nature of this lender-of-last-resort funding is the key point that separates it from a bailout.

Taken together, these and the other recommendations in the report released today point the way toward the end of too-big-to-fail.

White papers from the FRRI’s four other task forces – Capital Markets, Consumer Financial Protection, Regulatory Architecture, and Systemic Risk – are forthcoming. Similar to this paper, they will analyze what is working in Dodd-Frank, what is not working, how it can be improved, and what, if anything, was missed.