FDIC Says Dodd-Frank Act Ends “Too Big To Fail” Era

September 3, 2010 – FDIC Chairman Sheila Bair, in testimony before the Financial Crisis Inquiry Commission discussed how future systemic risks can be better managed and reduced under provisions of the Dodd-Frank Act.  Chairman Bair also said that new liquidation authority under the Act is a fundamental factor that will allow the U.S. to end the practice of “Too Big to Fail” for large financial institutions.

Chairman Bair noted that the financial crisis required unprecedented intervention by the Government to restore market order.  Although the economy and financial system are recovering, the widespread economic damage caused by the financial crisis will be felt for some time to come.   Fundamental reforms enacted by the Dodd-Frank Act are intended to prevent a future financial crisis.

Commenting on the Dodd-Frank Act, Ms. Bair stated that “If properly implemented, these provisions will not only reduce the likelihood of future financial crises but will also provide effective tools to address large financial company failures when they do occur without resorting to taxpayer-supported bailouts or damaging the financial system”.  The Dodd-Frank Act empowers regulators to identify both bank and nonbank institutions that may represent systemic risk.  Combined with a credible resolution process, regulators should be able to proactively prevent future crises.

Ms. Bair noted that regulators were unable to manage the crisis as it unfolded due to misaligned incentives by different parties in the mortgage securitization process, differences in regulatory authority over institutions in the banking system and shadow banking system, and an almost complete lack of regulatory control over the derivatives market.  In addition, the absence of a credible, preplanned resolution process for large, complex financial institutions lead to the absence of market liquidity as institutions became wary of lending to one another.  Without an effective resolution mechanism in place, regulators’ ability to manage the crisis was severely impaired.

The failures of Washington Mutual (WaMu) and Wachovia Bank were cited to illustrate the difficulties of resolving large, complex financial institutions under regulatory rules in place at that time.  Chairman Bair stated that “because holding companies of large banks and non-bank financial companies were subject to the Bankruptcy Code when they ran into trouble, their failures were much more difficult to resolve without either bailing-out stakeholders or causing systemic risk to the financial system. Failing non-bank financial companies also could only be resolved under the Bankruptcy Code, further exacerbating the financial crisis”.

Chairman Bair cited the severe blow to the financial system caused by the failure of $600 billion Lehman Brothers to showcase the critical shortcomings of the commercial bankruptcy process as a crisis resolution method.  Large institutions, by virtue of extensive counterparty exposure, create systemic risk since their failure could cause losses to counterparties which lead to additional failures, destabilizing the entire financial system.  Bankruptcy does not resolve financial firms in a manner that minimizes economic disruptions.

Chairman Bair noted that Lehman Brothers is still in Chapter 11 bankruptcy, $75 billion in value to investors has been destroyed and fees for the Lehman bankruptcy already amount to $918 million.  By contrast, the receivership process used for WaMu and Wachovia resulted in swift resolutions, calming financial markets and minimizing economic disruption and market panic.

The resolution of WaMu, which had a relatively simple financial structure, resulted in no losses to the FDIC Deposit Insurance Fund (DIF)- losses went to unsecured creditors.  Wachovia Bank, a much more complex financial institution, was acquired by Wells Fargo in an unassisted bid and also did not result in a loss to the DIF.  WaMu ($307 billion in assets) and Wachovia ($782 billion in assets) were the largest federally insured  banking institutions ever to fail or require government assistance.

The recently enacted reform bill addresses three critical areas of FDIC concern – resolution authority, systemic oversight and consumer protection.  Chairman Bair noted that:

On resolution authority, the new law gives the FDIC broad authority to use receivership powers, similar to those used for insured banks, to close and liquidate systemic financial firms in an orderly manner. On systemic oversight, it creates the Financial Stability Oversight Council (FSOC) to provide a macro view to identify and address emerging systemic risks and close the gaps in our financial supervisory system. Regulators also are empowered to provide much-needed oversight to derivatives markets. On consumer protection, the unregulated shadow financial sector is finally being placed under the oversight of a Consumer Financial Protection Bureau (CFPB) that will set and maintain strong, uniform consumer protection rules for both banks and non-bank financial firms.

Under the Dodd-Frank Act, FDIC regulatory authority is expanded to a non-bank financial companies with at least $50 billion in assets.  A failed, systemically important non-bank, can now be resolved in a similar manner to that of FDIC insured depository institutions.   The Act also empowers the FDIC to have advance access to information necessary to resolve a large, complex financial company in an orderly manner.  The Dodd-Frank Act’s purpose is to avoid another market meltdown by minimizing moral hazard, mitigating systemic risk, providing for orderly liquidation of non-bank financial companies and ending “Too Big to Fail”.  The FDIC has already established a new division (Office of Complex Financial Institutions) to deal with systemic risk and resolution of failed institutions (see FDIC Creates New Divisions).

Chairman Bair stated that her highest priority is to assess the risk of non-bank financial companies.

One of the highest priorities is identifying the universe of non-bank financial companies that—because of their leverage; off-balance sheet exposures; nature, scope, size, scale, concentration, interconnectedness, and mix of activities; or other factors identified in the Dodd-Frank Act—should be subject to enhanced prudential supervision by the FRB. Among other things, these determinations are critical to ending the regulatory arbitrage that played such an important role in the crisis. Identifying these companies is so critical since this determination triggers the requirement for the nonbank financial company to file an orderly resolution plan with the FRB and the FDIC.

Chairman Bair also called on the financial sector to allocate capital in a more productive manner to achieve solid long term economic growth.

If financial reform is about anything, it is about better aligning incentives and internalizing the costs of leverage and risk taking so that financial institutions can safely and efficiently channel capital to its highest and best use in our economy. During the run-up to the crisis, far too much money was directed toward booming, oversupplied real estate markets. The bust that followed is clear evidence that capital had been badly misallocated and could have put to far more productive use in areas such as energy, infrastructure or the industrial base. If our economy is to prosper, and if our nation is to meet the economic challenges looming ahead, our financial sector simply must do its job better.

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