Is 'Too Big To Fail' Really Over?

The architects of last summer's Dodd-Frank financial regulation bill hailed it as the solution to the "too big to fail" problem. The new non-bank resolution authority intends to make failure of the largest and most interconnected firms possible without jeopardizing the broader economy. The Federal Deposit Insurance Corporation released a proposed rule (.pdf) on Tuesday helping to explain how this new resolution process might work in theory. But will it work in practice?

Before getting into the key section of the FDIC's proposal, it will help to imagine a scenario where the non-bank resolution authority would be used. That's when a big financial firm collapses and poses a systemic risk to the economy. So let's pretend that the FDIC had this power in 2008 when AIG ran into trouble.

As the FDIC begins to wind down AIG, it needs to make good on AIG's obligations, like those to creditors and counterparties. Indeed, this was a major reason for the bailout, as banks and others were compensated by AIG once it got the government cash.

Of course, this needs to happen pretty quickly, since financial stability lies in the balance. The panic and uncertainty needs to be stomped out. As a result, the FDIC won't have time to determine precisely how much AIG's assets are worth. So it must assume that it will have some amount of money to distribute.

The FDIC explains that it will then prioritize that money to be provided to whichever firms or investors need most what they're owed to stabilize the financial system. Ultimately, however, they're only entitled to whatever amount they would have got under Chapter 7 bankruptcy. It's easy to imagine a situation where that's less than what they're provided at first very quickly to end the emergency.

Now let's turn to a section of the FDIC's proposed rulemaking, which really just clarifies and summarizes a portion of Dodd-Frank. It explains how this problem of giving firms more than they are entitled to will be handled:

The Dodd-Frank Act also includes the power to "claw-back" or recoup some or all of any additional payments made to creditors if the proceeds of the sale of the covered financial company's are insufficient to repay any monies drawn by the FDIC from Treasury during the liquidation. 12 U.S.C. 5390(o)(1)(D). This provision underscores the importance of a strict application of the authority provided in sections 210(b)(4), (d)(4), and (h)(5)(E) of the Dodd-Frank Act and will help ensure that if there is any shortfall in proceeds of sale of the assets the institution's creditors will be assessed before the industry as a whole. Most importantly, under no circumstances in a Dodd-Frank liquidation will taxpayers ever be exposed to loss.

In short, the FDIC will demand any excess money provided to creditors back at some point. This is done so that taxpayers cannot be on the hook for any of that money.

Let's reflect. The purpose of this new non-bank resolution authority is to quickly wind down systemically relevant financial firms so to restore certainty and calm to the market. But that end might not be accomplished through this process. Imagine AIG again. Let's say the FDIC decided that some big bank would be provided $3 billion out of the $4 billion it was owed, amounting to 75 cents on the dollar. That might not be ultimately what the big bank is awarded, however. It may only get 50 cents on the dollar, or $2 billion. That would result in AIG clawing back $1 billion and creating another hole in the bank's balance sheet in future quarters.

If investors understand this possibility, it's hard to see how the uncertainty driving a panic will be mostly eliminated. Because remember, in the case of AIG, there wasn't just one big bank provided proceeds, there were a dozen or more that were dependent on large sums of cash that they got when AIG was bailed out. So anything awarded quickly by the non-bank resolution authority would be temporary, and not finalized for some time. Will this really calm the financial markets? There would still be an awful lot of uncertainty left in the market.

Of course, the existence of a non-bank resolution authority is certainly better than not having one at all. In situations where just one big financial institution is collapsing in isolation, then it should be easily to restore sanity to a worried market through this new process. But in a situation like the recent financial crisis, when so many firms are in danger, it's hard to see how panic will be eliminated as long as significant uncertainty persists.