Resolution Triggers for Systemically Important Financial Institutions

• Publication year: 2021
• Citation: Vol. 97

97 Nebraska L. Rev. 65. Resolution Triggers for Systemically Important Financial Institutions

Resolution Triggers for Systemically Important Financial Institutions

John Crawford(fn*)

TABLE OF CONTENTS

I. Introduction .......................................... 65

II. Background Concepts ................................. 69
A. Banks, Shadow Banks, and Bank Holding Companies ........................................ 69
B. Capital and Liquidity .............................. 72
C. Bankruptcy, Bank Resolution, and the Orderly Liquidation Authority ............................. 75

III. Trigger Problems ..................................... 80
A. The Wrong Trigger: Liquidity ...................... 80
B. Capital and Timeliness ............................ 87
1. The Costs of Delay ............................ 87
2. Causes of Delay ............................... 94

IV. The Path Ahead ...................................... 104
A. Bolstering the Public Liquidity Backstop ........... 105
B. Promoting Timeliness ............................. 106
1. Background: Prompt Corrective Action ......... 106
2. Establishing Clear Guidelines and Addressing Capital's Shortcomings ......................... 107
C. Right-sizing the Loss-Absorbing Buffer ............. 116
D. Regulatory Discretion ............................. 118

V. Conclusion ............................................ 119

I. INTRODUCTION

When Lehman Brothers filed for bankruptcy in September 2008, it triggered a panic in financial markets that threatened catastrophic harm to the real economy.(fn1) Regulators, who had already worked to

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prevent the default of major financial firms,(fn2) redoubled their efforts, putting taxpayer money at risk as they recapitalized large financial firms and guaranteed their liabilities in order to prevent further failures.(fn3)

These events served to illustrate a classic dilemma regulators too often face when a large financial firm totters: allow the firm to fail and risk panic and catastrophic contagion, or bail it out, putting taxpayers at risk and exacerbating "moral hazard."(fn4) Firms whose imminent failure would force regulators to make this type of choice are "too big to fail."(fn5) One of the central themes of post-crisis reforms has been tackling the too-big-to-fail problem by trying to ensure that systemically important financial institutions (SIFIs) can fail while neither sparking a broader panic nor requiring taxpayers to cover losses for the SIFIs' creditors.(fn6) Solving this problem is vital, as the essential conditions that could spark a financial crisis and SIFI failures persist.(fn7)

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Scholars and regulators have made significant progress in navigating a path between the twin dangers of bailout and contagion once a decision is made to place a SIFI into either bankruptcy or resolution, the two special legal processes for dealing with failed financial firms.(fn8) (Unless otherwise specified, I will use "resolution" in this Article to refer to either legal process.)(fn9) There is, however, a significant lingering weakness both in the legal scholarship and in the on-the-ground reforms: the lack of appropriate guidelines informing the decision to trigger the resolution process in the first place. The weakness is significant, as failure to get the trigger right could exacerbate crisis dynamics and undo much of the work regulators have done to address the too-big-to-fail problem.(fn10) This Article addresses this weakness, identifying significant obstacles to an optimal triggering framework in the current regulatory landscape and proposing reforms to help achieve such a framework going forward.

Two overlapping challenges confront regulators in designing an optimal triggering framework: choosing the correct triggering metric and ensuring the timeliness of the decision to pull the trigger. The principal options for triggering resolution are (i) "balance sheet" insolvency, when the value of a firm's assets falls below its liabilities; and (ii) illiquidity, when a firm runs out of cash and easily saleable assets.(fn11) I argue below that while either option is appropriate for nonfinancial firms, balance sheet insolvency is the appropriate trigger for financial institutions.(fn12) Using liquidity as a trigger risks needlessly shutting down a viable financial institution.(fn13) More importantly, it

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creates perverse incentives on the part of firms trying to avoid resolution-prompting them to hoard liquidity at the very moment the market most needs these institutions to use their cash to lend to and buy from others.(fn14) This problem has particular salience because the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), under current guidance for the mandatory SIFI pre-bankruptcy plans popularly known as "living wills," have pushed SIFIs to include a liquidity tripwire for a bankruptcy filing.(fn15)

Even if one uses a solvency-based trigger, however, timeliness remains a challenge due to biases on the part of private actors and regulators to delay pulling the trigger, and to the fact that regulatory measures of capital often lag real economic developments.(fn16) There is nothing in the principal SIFI resolution mechanism established by the Dodd-Frank Act, titled the Orderly Liquidation Authority (OLA), that mitigates or counteracts these factors. This is a problem because waiting too long to pull the trigger could undermine the work done to eliminate the too-big-to-fail dilemma. A key element of the "solution" to the too-big-to-fail problem is ensuring that SIFIs have sufficient loss-bearing capacity-essentially, claims on the firm that do not pose a "run" risk,(fn17) as deposits do-to absorb all the SIFI's losses, but delay allows losses to metastasize. If losses grow large enough, they may require regulators again to decide whether to engage in a bailout or to impose losses on deposit-like creditors, which could spark a panic.(fn18)

This Article's analysis yields several important policy implications. First, liquidity-the cash or easily saleable assets a firm holds- should not be used as a trigger for placing a SIFI into bankruptcy or resolution.(fn19) A second implication follows from the first: as long as we tolerate vast amounts of uninsured short-term debt funding for nondepository institutions,(fn20) post-crisis restrictions on emergency lending to SIFIs by the Federal Reserve should be relaxed.(fn21) Third, it is important to establish clearer guidelines for triggering resolution proceedings at the right moment. A promising framework already exists; it was set forth in an "early remediation" rule that was proposed in 2012 but never finalized.(fn22) The trigger problem would be significantly

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mitigated if this rule were finalized and implemented. Fourth, the use of market measures of solvency should be explored.(fn23) These measures, which could be employed instead of or in addition to regulatory capital measures, could potentially improve the timeliness of triggering decisions. (The yet-to-be-finalized early remediation rule provides a mechanism for exploring the use of market measures in a cautious way.) Finally, to the degree concerns about timeliness persist after other steps have been implemented, regulators should consider increasing the amount of "loss-absorbing" long-term debt SIFIs are required to issue.(fn24)

Part II of this Article provides a brief account of background concepts essential to the arguments of the piece. Part III lays out the gaps and obstacles in the current regulatory landscape that impede the realization of an optimal framework for triggering resolution. Part IV proposes steps for achieving such a framework, and Part V concludes.

II. BACKGROUND CONCEPTS

Understanding the arguments about resolution triggers requires a baseline understanding of certain key institutions and concepts. This Part briefly provides the necessary background, describing the key entities at issue, the most prominent candidates for triggering metrics, and different mechanisms for dealing with failed firms. Readers familiar with this background material may wish to jump ahead to Part III.

A. Banks, Shadow Banks, and Bank Holding Companies

Banks. As used in this Article, a "bank" with no other qualifier, and unless otherwise noted, is a generic term for depository institutions. These include commercial banks, thrifts, and other legal entities that may receive deposits and enjoy federal deposit insurance.(fn25)

Shadow Banks. "Shadow banking," as used in this Article, refers to non-banks-such as broker-dealers-that adopt a bank's financing model: namely, using money raised by issuing large quantities of short-term debt to fund portfolios of long(er)-term financial assets.(fn26)

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While non-banks are legally prohibited from issuing deposits,(fn27) it turns out that they can comply with the letter of this rule while violating its spirit by issuing the functional equivalent of deposits. These deposit equivalents include instruments such as commercial paper or "repo loans."(fn28) For the short-term debt claimant of a shadow bank, the transaction serves as a close substitute for a bank deposit-that is, it serves as a safe mechanism for storing cash until it is needed to meet some transactional purpose.(fn29) Just as a bank funds (long-term) mortgages or commercial loans with demand deposits that mature continuously...