The collapse of the investment bank Lehman Brothers in September 2008 was perhaps the defining event of the financial crisis. Lehman’s bankruptcy, followed by the near-collapse (save for government intervention) of the insurance company AIG, greatly intensified the fear and panic in markets, bringing the financial system and the economy to the brink of the abyss.
These events, including the government’s response, remain controversial. What should not be controversial is that ordinary bankruptcy procedures were entirely inadequate for the situation. The bankruptcy judge in the Lehman case—required, by law, to focus narrowly on adjudicating creditors’ claims against the company—had neither the tools nor the mandate to try to mitigate the effects of the failure on the financial system or the economy. The Fed, FDIC, and Treasury used the powers available to them, often in ad hoc ways, to try to preserve broader stability. But these agencies likewise lacked a framework for dealing systematically with failing financial giants.
The architects of the Dodd-Frank Act, which reformed financial regulation after the crisis, recognized that—in order to make the financial system safer and eliminate future taxpayer-funded bailouts—a better approach was needed. The first two sections, or titles, of the bill aimed to do just that. Title I extended the ordinary bankruptcy framework to better accommodate the complexities of large, interconnected financial firms. It also required large bank holding companies to submit to their regulators plans for how they could be successfully resolved in a crisis (“living wills”).
The Dodd-Frank law presumed that failing financial firms would be resolved through Title I procedures if possible. But it was recognized that, during periods of high financial stress, even augmented bankruptcy procedures might not be enough to maintain a stable financial system. Accordingly, Title II of Dodd-Frank created a backup authority, called the Orderly Liquidation Authority (OLA), to be used only when the Fed, FDIC, and Treasury (in consultation with the President) declare a financial emergency. Under the OLA, the FDIC and Fed are provided tools to help resolve failing firms safely, in a way analogous to the approach that the FDIC has long used to resolve failing banks. The creation of the OLA was accompanied by the repeal of some of the powers used by the Fed, FDIC, and Treasury during the crisis (such as the Fed’s ability to make an emergency loan to a single firm that is not a bank). The logic, which I supported as chair of the Fed, was that with the new authority in place those earlier powers were no longer needed.
Unfortunately, Title II and the OLA have now become a target of some in Congress. Particularly worrying for Title II supporters is that Senate parliamentary procedures may allow the OLA to be repealed with only 51 votes in the upper house, rather than with the 60 votes needed to overcome a filibuster.[1] Critics argue that OLA legitimizes bailouts and reinforces the perception that some firms are too big to fail; to avoid that outcome, they would like a (possibly enhanced) Title I bankruptcy to be not only the preferred option but also the only option for a failing financial firm.
In my view, repealing Title II to eliminate the OLA would be a major mistake, imprudently putting the economy and financial system at risk. The OLA is not perfect—indeed, its implementation remains a work in progress—but it is an essential tool for ensuring that financial stress does not escalate into a catastrophic crisis. In the remainder of this post I argue that, under crisis conditions, the OLA (Title II) framework—which, unlike Title I, makes full use of the information and expertise of financial regulators—would be much more likely than a Title I process to safely unwind a failing, systemically important firm. Moreover, the existence of the OLA option does not institutionalize bailouts of failing financial firms. To the contrary, under the OLA all losses are borne by the private sector, not by taxpayers. Indeed, if no OLA were available, it’s more rather than less likely that some future policymakers would conclude that bailouts were the only viable option to protect the economy.
Resolving a firm in a crisis: judges versus financial regulators
Title I could be improved and aligned better with Title II (see for example this piece by my Brookings colleagues Martin Baily and Douglas Elliott). However, no matter what tweaks are made to Title I, a bankruptcy is a legal proceeding overseen by a judge or panel of judges. It is simply not plausible that judges would be as effective as financial regulators in preparing for a speedy resolution or in managing one during a period of high financial stress. When the financial system is in turmoil, we should want to retain the option of a (Title II) OLA resolution.
Why are regulators better equipped than judges to achieve an effective resolution in a crisis? First, as financial supervisors, the Fed and the FDIC have extensive, granular knowledge of the balance sheets and operations of the largest firms. A resolution likely would take place over a period of at most several days (perhaps a weekend), placing a premium on advance knowledge and expertise. Indeed, both the Fed and the FDIC have devoted extensive staff resources to detailed planning for the resolutions of major firms, with the FDIC in particular drawing on its decades of experience in resolving banks. A judge or panel of judges could not replicate this knowledge without effectively becoming a full-fledged supervisory agency itself.
Second, financial regulators also regularly monitor markets and the financial system as a whole; this market intelligence could prove critical as regulators try to assess the effects of alternative resolution strategies on overall financial stability. Again, this type of information would not generally be available to a judge or panel of judges, nor is it their remit or comparative advantage to gather it.
Third, the resolution of a large, internationally active firm would inevitably involve coordination with foreign financial regulators and central banks, who bear the responsibility for resolving financial firms in most other jurisdictions. U.S. financial regulators work regularly with their foreign counterparts, and have done considerable joint planning on resolution strategies (see for example this collaborative effort by the FDIC and the Bank of England). Absent such consultation, including advance discussions, during a crisis foreign regulators would likely protect their domestic depositors and investors by “ring-fencing” the assets of the branches or subsidiaries of a troubled U.S. firm, which would prevent an orderly resolution of the firm at a global level. It’s unlikely that U.S. judges could establish similar relationships with foreign regulators in advance of or during a crisis. In short, financial regulators applying the OLA would be much more likely than a judge to achieve an outcome that protected the financial system as a whole as well as the firm’s creditors.[2]
But isn’t OLA a bailout?
So why the opposition to the Title II authority? Critics of the OLA view it as a thinly disguised, taxpayer-funded bailout. In particular, they point out that the law allows the FDIC to use funds borrowed from the Treasury to provide temporary liquidity support to a firm that is being resolved. (The FDIC can borrow up to 10 percent of the firm’s pre-resolution assets or 90 percent of assets available for repayment.) This in turn, they argue, encourages the market to perceive that some financial firms are “too big to fail.” We know that this perception creates numerous problems. For example, if investors believe a firm has implicit government backing, they will lend to it cheaply (creating an uneven playing field with other firms) and will be indifferent to the possibility that the firm is making bad decisions or taking excessive risk. Lack of market discipline likewise provides distorted incentives for managers.
Dodd-Frank uses a range of approaches to mitigate the too-big-to-fail problem, including tougher capital requirements and supervisory restrictions on the largest, most complex firms. The living will requirement is itself a proactive attack on too-big-to-fail, in that it requires firms to show that they can be resolved—and if not, to simplify or downsize.
The key point regarding OLA, though, is that a resolution under Title II was explicitly designed not to be a bailout, in that all costs are borne by private actors, most especially stakeholders in the failing firm. In particular, an OLA resolution during a crisis would hardly feel like a bailout to the firm’s owners and managers, who would see the extinction of the firm’s equity and the wholesale replacement of its board and management. In addition, regulators now require that large financial holding companies issue substantial amounts of debt, with the advance understanding that this debt can be zeroed out or converted to equity in a resolution. This extra debt—part of what regulators call the firm’s “total loss-absorbing capacity,” or TLAC—provides a significant cushion of protection against losses. In short, under OLA, the firm’s losses are borne by shareholders, managers, and creditors—they are not bailed out. There is no provision for the government to put capital into a failing firm, as was done under the TARP program during the crisis.
As noted, the possibility that the FDIC could borrow from the Treasury to lend to a troubled firm draws particular ire. A temporary liquidity backstop is likely to be necessary to maintain critical operations as the firm is restructured (and the same sort of backstop would likely be as needed under a Title I resolution as well).[3] Importantly, though, these loans are limited in size and are temporary funding, not permanent capital. They are backed by first claims on the firm’s assets and—if that is not enough—by an assessment on other large financial firms. The one group that is guaranteed not to see losses in an OLA is taxpayers.
Finally, it’s worth stressing that a resolution under the OLA could be used only if several decisionmakers, including the Secretary of the Treasury in consultation with the President, affirmed that U.S. financial stability is at risk. Otherwise, Title I bankruptcy procedures would apply.
Conclusion
Recent experience has taught us that the uncontrolled collapse of a systemically important financial firm can do enormous damage to the broader financial system and the economy. The Dodd-Frank Act modified bankruptcy law to better accommodate large, complex financial firms, but also wisely provided a backstop framework—the Orderly Liquidation Authority of Title II—that can be invoked when overall financial stability is at stake. Critically, the OLA draws on the expertise and planning of the FDIC and the Fed. The OLA is not a bailout mechanism, since all losses are borne by the private sector. The government can provide temporary liquidity under OLA (as it probably would have to do under Title I, as well), but not permanent capital. Taxpayers are fully protected.
To be sure, controversies remain over how effective in even a Title II resolution would be in the context of a significant financial crisis. Still, drawing in particular on the FDIC’s decades of experience in dealing with failing banks, a good bit of progress has been made. The tools provided by Title II are a significant advance over what was available during the recent crisis.
Have we ended bailouts? Current lawmakers can’t bind future legislators, and we can’t guarantee that a future administration and Congress, fearful of the economic consequences of a building financial crisis, won’t authorize a financial bailout. But the best way to reduce the odds of that happening is to have in place a set of procedures to deal with failing financial firms that those responsible for preserving financial stability expect to be effective. That’s what the OLA is intended to provide.
[1] A simple majority only is needed to pass bills with a budgetary component. Because the OLA includes the possibility that the Treasury could provide short-term liquidity to a firm in resolution, the Congressional Budget Office “scores” the OLA as having a budgetary cost and thus subject to a potential 51-vote repeal. However, as discussed further in the text, loans made by the Treasury are secured not only by the firm’s assets but by a requirement in the law that any losses be made up by an assessment on the financial industry; as Larry Summers has pointed out, the CBO’s scoring is an artificial outcome of the ten-year budgeting window (the possibility that a loan could be made in year nine and paid back, say, in year eleven) rather than an economically meaningful potential loss. Alternatively, as David Skeel points out, even if the OLA is retained, Congress could hamstring it by repealing only the temporary funding component of Title II.
[2] Title II protects creditors by requiring that they receive as much in an OLA resolution as they would in a Title I proceeding.
[3] In some bankruptcies, so-called debtor-in-possession financing is provided by the private market. Private financing could not be counted on for a failing financial firm, however, because financial firms are opaque (their assets are hard to value on short notice) and because the use of the OLA implies that broader financial conditions are highly stressed.
Comments are now closed for this post.