How to eat an elephant: corporate group structure of systemically important financial institutions, orderly liquidation authority, and single point of entry resolution.

• Author: Jin, Kwon-Yong

INTRODUCTION I. ORDERLY LIQUIDATION AUTHORITY (OLA): KEY PROVISIONS A. Statutory Framework of the Orderly Liquidation Authority B. The FDIC's Roadmap for Implementation of the OLA: Single Point of Entry (SPOE) II. GOALS OF AN OPTIMAL RESOLUTION STRATEGY III. ADVANTAGES OF THE OLA AND THE SPOE STRATEGY A. The SPOE Approach Enables Quick Resolution of a Large Financial Group B. The SPOE Approach Reduces Moral Hazard for the Parent's Creditors and Shareholders C. The SPOE Approach Maintains Stability While a Firm Is in Resolution IV. CORPORATE GROUP STRUCTURE AND DISADVANTAGES OF THE OLA A. The SPOE Strategy Increases the Moral Hazard of the Subsidiaries' Creditors B. The SPOE Strategy Encourages Financial Groups To Shift Liabilities to Their Subsidiaries C. The SPOE Approach Relies on an Unrealistic Assumption of Clear Asset Segregation V. IMPROVING THE OLA AND THE SPOE STRATEGY A. The FDIC Should Embrace an Expanded Government Backstop but Impose Corresponding Costs To Reduce Moral Hazard B. Subsidiary-Level Stress Testing Can Be a Self-Enforcing Solution to the Asset Segregation Problem CONCLUSION INTRODUCTION

Financial institutions are, by nature, vulnerable to sudden failures in times of economic distress. Their business model often relies on one key characteristic: maturity transformation. (1) Through maturity transformation, financial intermediaries take the assets of depositors and other short-term lenders, pool those assets, and invest in long-term projects. (2) In this process, short-term assets are "transformed" into long-term assets. Maturity transformation connects lenders who have funds to invest but want access to them on short notice with borrowers who need funds for long-term projects. (3)

Maturity transformation has two important implications for the stability of the financial intermediary. First, because a financial institution cannot easily sell off the illiquid, long-term loans and other assets it holds, it must accept a significant discount for its assets when it is forced to liquidate them rapidly due to external pressures (often called a "fire sale"). (4) Second, a financial intermediary is almost always highly leveraged, meaning that its shareholders' equity is a tiny fraction of its total assets and that the financial intermediary funds its as sets largely by borrowing. (5) As a result of these characteristics, financial institutions are susceptible to liquidity runs that can cause insolvency. (6) In the event of a negative shock to the economy, lenders might rapidly withdraw their money from a financial intermediary (a liquidity run), and since many financial intermediaries only have a small sliver of equity, (7) they can easily fall insolvent if the initial phase of a liquidity run forces a fire sale of long-term assets and a consequent decrease in asset value. Facing the prospect of insolvency of the financial intermediary, the remaining lenders would also rush to withdraw their money, creating a vicious cycle.

This vicious cycle played a particularly prominent role during the financial crisis of 2007-08, especially in the failure of Lehman Brothers, which was then the fourth largest investment bank in the United States. (8) Because of the deterioration of the housing market that started in 2006, Lehman Brothers' real estate-related assets had created concerns in the market. Lehman had funded those assets with short-term loans (including repurchase agreements, or "repos"), with maturities as short as one day. (9) In normal times, Lehman was able to renew its overnight loans as they came due, as the providers of those loans continued to have faith in Lehman's ability to repay a day later. However, as concerns over the investment bank's balance sheet mounted, and those same lenders lost faith in Lehman's ability to repay, Lehman's funding dried up. Its counterparties refused to roll over short-term loans and demanded larger collateral for the same loan amount. (10) This process accelerated in the week leading up to September 15, 2008, when the investment bank collapsed. (11) The Chapter 11 bankruptcy of Lehman Brothers and the ensuing scramble for the investment bank's assets destroyed the remaining franchise value and pushed asset values down even further; Lehman's unsecured creditors recovered only twenty-one percent of their claims. (12)

This inherent instability of financial institutions creates the need for a resolution regime for systemically important financial institutions. Banks do fail, and when major banks fail, their failure damages the real economy tremendously. (13) For example, the financial crisis of 2007-08 left a tremendous credit gap, leading to a significant reduction in loans extended. (14) As a result of this "credit crunch," the unemployment rate in the United States shot up from 5.0% in December 2007 to 10.0% in October 2009. (15) While the risk of a financial institution failure may be mitigated ex ante by measures that regulate banks' balance sheet composition and risk metrics, (16) it may be impossible to prevent financial institution failures altogether. A certain degree of risk-taking by financial institutions is necessary if they are to fulfill their mission of connecting lenders with borrowers through maturity transformation. That risk-taking, however prudent, creates some possibility of failure. Therefore, ex ante measures must be coupled with an ex post resolution mechanism designed to wind down failing financial institutions in case of a crisis.

The Dodd-Frank Act's Orderly Liquidation Authority ("the OLA") is an answer to this call. (17) The failure of Lehman Brothers showed that there was no suitable mechanism for rehabilitating or liquidating a troubled investment bank. While the Federal Deposit Insurance Corporation (FDIC) had statutory power to wind down insured commercial banks, that power did not reach non-depository financial institutions, such as independent investment banks. (18) Therefore, before the OLA, policymakers had only two options for faltering in vestment banks: bankruptcy (for example, Lehman Brothers) or bailout (for example, Bear Stearns or AIG). (19) Neither option was attractive. The case of Lehman Brothers had shown that the Bankruptcy Code could not deal effectively with the failure of a large financial institution. Once Lehman filed for bankruptcy, its counterparties--whose "qualified financial contracts" were exempt from the Bankruptcy Code's automatic stay--effectively dismembered Lehman's derivatives portfolio, resulting in tremendous destruction of value. (20) Moreover, while ad hoc bailouts had saved several large financial institutions in 2008, they were also politically unpopular and criticized for encouraging moral hazard and excessive risk-taking. (21) Large, complex financial institutions, knowing that policymakers cannot let them fail lest their failure jeopardize the whole financial system, would take even more risks as a result of this implicit government backstop, increasing the size of their balance sheets in the process and creating a vicious cycle. The OLA aims to fill this gap, providing the FDIC with the power to wind down systemically important financial institutions in an orderly fashion.

Of course, quickly liquidating a major financial group in an orderly manner is no easy task. Large financial groups are behemoths with hundreds of subsidiaries and intricate webs of guarantees. To solve this problem, in December 2012, the FDIC proposed a Single Point of Entry strategy ("SPOE," "the SPOE strategy," or "the SPOE approach") for exercising its OLA powers. (22) Under SPOE, when a financial group is in danger of failing, the FDIC would place the parent company of that group into receivership but leave its subsidiaries out of resolution. (23) Next, the FDIC would transfer all assets of the parent to a bridge company and leave the debt behind, creating a well-capitalized bridge company that could assist the subsidiaries as needed. (24) Thus, by cancelling the debt of the parent ("bailing in" that debt), the FDIC could avoid putting operating subsidiaries into bankruptcy. (25) Those subsidiaries could continue to operate as usual, averting a disorderly collapse of a systemically important financial institution. (26)

In light of this description from the FDIC of its intended strategy for exercising its OLA powers and the lack of academic literature on this recent proposal, this Note argues that the SPOE strategy inadequately accounts for the corporate group structure of major financial institutions. First, the SPOE approach can encourage moral hazard by the creditors of the subsidiaries of a financial group: protected by the parent's creditors, the subsidiaries' creditors may not monitor the financial group's risk-taking activities. While the SPOE approach would reduce moral hazard at the parent level, theories of corporate group structure suggest that the parent's creditors would not be able to offset the moral hazard of the subsidiaries' creditors and that both the overall level of monitoring and the cost of credit for the financial group would decrease. Second, based on existing theory and empirical evidence from the 2008 financial crisis, this Note argues that clear asset segregation among affiliated legal entities is a key prerequisite to a successful liquidation under the SPOE approach. This prerequisite, however, is missing in many circumstances. (27) In response to these weaknesses, this Note puts forward a package of solutions, including an expanded FDIC backstop for troubled institutions and subsidiary-level stress testing.

This Note's contributions are twofold. First, it connects the theory of corporate organization with the theory of financial regulation. To date, most of the scholarly work on the regulation of financial institutions has focused on those institutions' peculiarities as monolithic financial institutions but not as corporate groups. The fact that these banks are organized...