The Bair necessities

Federal Deposit Insurance Corporation chairman Sheila Bair has argued that systemically important financial institutions should hold more capital as a disincentive to growth, while a new entity should be set up to manage the orderly resolution of troubled 'too-big-to-fail' firms. The proposals have received a mixed response from former regulators, but seem to have struck a chord with the US Treasury. Peter Madigan reports

Regulators have proposed a variety of fixes to the problems exposed by the financial crisis. Few, however, have been as bold as those suggested by Sheila Bair, chairman of the Federal Deposit Insurance Corporation (FDIC), in her testimony to the US Senate Committee on Banking, Housing and Urban Affairs on May 6.

Pre-empting many of the measures the Obama administration would go on to officially propose in its Financial regulatory reform: A new foundation white paper released on June 17, Bair suggested any financial institution that poses systemic risk should be forced to hold higher capital and liquidity buffers - a requirement that would act as a disincentive to growth and complexity. She also proposed the setting up of a systemic risk council comprising the FDIC, US Treasury, Federal Reserve Board and the Securities and Exchange Commission (SEC) to address issues that pose risks to the financial system. Finally, Bair recommended the setting up of a new entity that would have the authority to manage the orderly unwinding of large and complex financial institutions that face bankruptcy - and hinted the FDIC would be best placed to perform this role. All three of these proposals were ultimately included in the Treasury consultation paper.

"While no existing government agency, including the FDIC, has experience with resolving systemically important entities, probably no agency other than the FDIC currently has the kinds of skill set necessary to perform resolution activities of this nature," she said.

Former regulators have reacted positively to many of the proposals outlined by the US Treasury and by Bair - in particular, the suggestion that systemically important financial institutions hold additional capital and liquidity buffers.

Precise details on the level of additional capital were not provided on June 17, although the Treasury clarified that the size and leverage of a financial institution, as well as the effect its failure would have on the economy, would be among the factors used to determine whether a firm poses a threat to financial stability. Bair also suggested the buffers should address pro-cyclicality by requiring banks to hold additional capital during upswings in the economic cycle, which are then to be drawn upon during downturns - another proposal picked up in the Treasury reform plans.

While most welcome the idea of additional capital buffers, some former regulators doubt whether this will be enough to act as a disincentive to growth.

"I don't know that forcing banks to hold higher capital levels will lead them to shrink, or if the intent is even to compel them to downsize, rather than to provide a cushion to protect the bank during down-cycles," says Robert Clarke, a senior partner at law firm Bracewell & Giuliani in Houston and US comptroller of the currency from 1985 to 1992. "If the view is that banks need to hold higher capital, irrespective of what the Basel II models show, I think there will be an industry-wide effort to compel the banks to maintain higher levels of capital to avoid the pro-cyclical problem - not just among the biggest systemically important banks, but with all banks."

Others question whether requiring additional capital is the right way to go, suggesting it could be counterproductive. Instead, taxation might be a more effective means of discouraging financial institutions from growing too big, proposes William Black, associate professor of economics and law at the University of Missouri-Kansas City (UMKC) and former senior deputy chief counsel at the Office of Thrift Supervision.

"Capital charges would force these systemically risky institutions to shrink, but this can be a dangerous approach since banks might take imprudent steps to raise that capital. Perhaps more effective ways to achieve the same goal would be to impose a graduated premium corporate income tax that makes them pay for the fact they pose systemic risk, or a blanket injunction preventing them from acquiring other business units outright," he suggests.

The concept of a systemic risk council, meanwhile, has been praised by some observers. In her testimony, Bair said a distinction should be drawn between the direct supervision of systemically important financial institutions - a systemic risk regulator role that will be played by the Federal Reserve - and the systemic risk council. Indeed, the US Treasury's proposed Financial Services Oversight Council (FSOC) will be responsible for identifying firms, practices and markets that create systemic risks, as well as implementing measures that address these risks. The FSOC will be charged with identifying gaps in regulation and resolving jurisdictional disputes between regulators, and will have the authority to recommend which large institutions should be subject to special oversight and additional capital requirements due to their size, leverage and interconnectedness. However, the Federal Reserve would regulate systemically important institutions under the Treasury proposal.

"The Treasury has advocated that the Federal Reserve should be the systemic risk regulator, but that is a bad idea," says William Isaac, chairman of Washington, DC-based consulting firm The Secura Group and chairman of the FDIC from 1981 to 1985. "No one agency should be relied upon for that single function, and the political risk to the independence of the Fed should they miss a developing threat would be enormous. I wholly endorse a council of regulators that would perform the market stability function, gather up information from existing regulators, identify dangerous market bubbles and nip them in the bud."

However, the proposal that a new entity be set up to deal with the orderly unwinding of any large, complex financial institutions has met with a cooler reception. The FDIC chairman noted that markets were thrown into disarray following the collapse of Lehman because participants had thought the government would not let it fail, just as with Bear Stearns in March 2008, when regulators brokered its acquisition by JP Morgan. This ad hoc and inconsistent response to failing banks worsened the impact of the bankruptcy, argued Bair.

While the FDIC has resolution authority over insured depository institutions, it has no ability to take control of bank holding companies or non-bank entities. However, the holding company may not be able to survive without the funding and liquidity provided by the bank subsidiary. The only option available would be for the bank holding company to file for Chapter 11 bankruptcy protection, which may further destabilise the situation, said Bair.

"Putting the holding company through the normal corporate bankruptcy process may create additional instability as claims outside the depository institution become completely illiquid under the current system," explained Bair. "Without a system that provides for the orderly resolution of activities outside the depository institution, the failure of a large, complex financial institution includes the risk it will become a systemically important event."

As an example, Bair noted that if a bank (or non-bank) holding company is forced into bankruptcy, there would be an automatic freeze on most creditor claims. At the same time, the entity's financial market contracts would be terminated, and would not be permitted to be transferred to another existing institution or a temporary bridge bank. Without a bridge bank or other similar entity, there would be no practical way for the holding company or its subsidiaries to continue operations.

"As a result, the current bankruptcy resolution options available - taking control of the banking subsidiary or a bankruptcy filing of the parent organisation - make an effective resolution of a large, systemically important financial institution, such as a bank holding company, virtually impossible," Bair added.

The US Treasury plans to resolve failing systemically important banks align relatively closely with Bair's statements. New authority would permit either the Treasury or the Federal Reserve to initiate the takeover of a bank. The process could also be initiated by the FDIC, or by the SEC if the largest subsidiary of the failing entity is a broker-dealer or a securities firm.

Following consultation with the president and upon the written recommendation of two-thirds of both the Federal Reserve Board and the FDIC (or the SEC if the largest subsidiary is a broker dealer) special resolution authority to assume control of the ailing firm would be granted. To invoke this authority, however, the Treasury would have to determine that the firm is in danger of default, its collapse would seriously adversely affect the financial system and resolution intervention by the government would mitigate these impacts. The Treasury "should generally appoint the FDIC to act as conservator or receiver" in most cases, the white paper reads, although the SEC could fulfil this role if the institution in question is a broker-dealer or securities firm.

The suggestion the FDIC will be given power to resolve systemically important banks has been criticised by some former supervisors. "Regardless of whether we need new powers to replace the existing bankruptcy statutes, I have a hard time seeing the FDIC as the body to wield that authority," says Bracewell & Giuliani's Clarke. "It is a depository insurer - that's its business and that is what it ought to stick to. There are arguments it shouldn't even be a bank supervisor but should limit itself to its insurer role, let alone dismantle large institutions."

The scepticism was echoed by the American Bankers Association (ABA). In a letter to US Treasury secretary Timothy Geithner on April 14, the ABA wrote: "Only once has the FDIC handled what might be considered a systemically important resolution - Continental Illinois - and by today's standards that was small and not at all complex."

Others feel the FDIC may well be the right agency to take on this role, but raise concerns about staffing and funding. While regulators are currently beefing up the number of staffers working for them, it will be difficult to maintain this momentum during a prolonged period of benign economic conditions.

"If the US Congress is going to pass this resolution authority, the FDIC - if properly staffed and funded - is clearly the only agency equipped to handle it. One problem is this boom-and-bust mentality at the corporation - staffing up when a crisis hits and then shedding staff after the crisis abates. The FDIC has recently hired more than 100 retired examiners to help them with the latest spate of examinations. I don't think that pattern is preparing them well for the type of role the FDIC will have if it takes over these additional responsibilities," says Nicholas Ketcha, a director at New Jersey-based consultancy FinPro and former director of supervision at the FDIC.

Bair proposed the entity be funded by fees charged to systemically important firms, imposed either before failures or following an assessment after a resolution. Recommending a pre-funded model, this 'financial companies resolution fund' would mainly cover administrative costs of managing an unwinding. In the Treasury white paper, it states the receiver will borrow from the Treasury to fund resolutions - the costs of which would be paid from the proceeds of assessments on bank holding companies.

Taken together, the measures are designed to prevent the growth of systemically important firms. Bair argued the established thinking prior to the crisis - that size equals diversity and economies of scale - was shown to be faulty. Instead, there ended up being a few very large, complex firms conducting the majority of transactions, leading to a concentration of risk.

However, this logic is questioned by some. Wayne Abernathy, executive director for financial institutions policy and regulatory affairs at the ABA in Washington, DC, points out that a return to smaller, regionally focused banks could lead to further failures, such as California-based IndyMac.

"I think we would have a lot of IndyMac-type entities if we were to move to a model where we broke up larger banks into smaller banks and had instead all banks worth $100 billion or less, because we would have firms very vulnerable to the downturn of a regional economy. IndyMac was brought down because it was concentrated in the housing bubble and subsequent housing bust in California, without earnings anywhere else to offset the losses. To some extent, the same situation applies to Washington Mutual, which was heavily concentrated along the west coast of the US," he notes.

Despite being a Republican operating alongside a Democrat-controlled Congress and White House and a strongly interventionist Treasury department, Bair appears to have found ideological allies willing to support her proposals. "Both Sheila Bair's rhetoric and her actions are without question the most encouraging in the US financial regulatory sector today, but I am dubious that we really are moving against banks that are posing systemic risk," says Black of UMKC. "Bair is making the right noises, granted. But I can see few other regulators coming out with serious proposals when they talk about the risks posed by these systemically dangerous institutions."

Adair to Bair: I want to be like you

As Sheila Bair seeks stronger resolution authority for the Federal Deposit Insurance Corporation, regulators in the UK are mulling how best to tackle similar challenges and considering similar solutions.

In a speech on April 27, Financial Services Authority chairman Adair Turner stated: "We should make it clear there is no too-big-to-fail category, and if we define well in advance how we would resolve rather than support even the very largest banks, imposing suitable haircuts on non-insured bondholders and creditors, we could reintroduce market discipline. But there would be huge problems with such an approach. I suspect we simply have to accept there is a too-big-to-fail and too-connected-to-fail category."

Turner rejected the imposition of a Glass-Steagall Act-type distinction between investment banks and classic commercial banking, noting that both types of institution have proven equally susceptible to collapse during the market crisis. He favours the imposition of new capital and liquidity regimes for trading activities, which he asserted "would almost certainly result in an increasing number of banks choosing to focus entirely on classic commercial banking activities".

Turner insisted, however, that UK regulatory authorities "should be open-minded to a third way forward, which is that large, systemically important, too-big-to-fail banks should have to maintain higher capital ratios than applied on average. There would be implementation difficulties in such a strategy. It would require the definition of which banks are systemically important and too-big-to-fail, but it is certainly a possible way forward and should be evaluated alongside work on the details of the capital and liquidity regimes," Turner stated.