Will the FDIC's New Power End 'Too Big To Fail'?

The crown jewel of last summer's giant financial regulation bill was the new non-bank resolution authority. While many provisions attempted to end the "too big to fail" problem, the only one with teeth was the Federal Deposit Insurance Corporations new power to swiftly and neatly take control of giant failing firms and wind them down, much like it does with troubled banks. This week, the FDIC released some details (.pdf) on how its new non-bank resolution authority would work. While it does look like a step in the right direction, it still faces some obstacles.

The Good: Business Continuation

In general, the resolution authority looks pretty good. It has one very important issue taken care of: the continuation of business of a failing firm. Take the failure of Lehman for example. As it collapsed, all its thousands of derivatives counterparties were wondering what would happen to their agreements. Would they have to spend years in court to get the periodic payments that contracts promised?

If the FDIC could have stepped in, then it could have ensured business continuity by creating a receivership or bridge financial company to make necessary payments. It has done this historically for failing banks, with great success. So this is one fear that the market will no longer have related to giant firms failing. Even if the firm fails, chaos may be avoided.

The Not-As-Good: Uncertainty Lives

The FDIC has anticipated some problems that could arise through the new process and has offered solutions. For example, one issue was that some unsecured creditors might be provided a higher priority than others due to systemic risk or other concerns, but the FDIC assures us that all creditors of a given class will receive the same treatment they would in a Chapter 7 bankruptcy. Preference won't be given to long-term creditors over short-term creditors or vice-versa.

Of course, making that happen at a time when a financial crisis is underway might be a little tough. For example, how can the FDIC accurately determine how much money a bank's assets are worth? It would have to make some good estimates in order to determine how to fairly divide up the money among creditors. This problem is particularly important with regard to creditors that need to collect this money quickly, in order to avoid contagion in the market due to a firm's failure.

This could result in a situation where the FDIC rushes to pay out a creditor, and accidentally awards more than it should have, leaving insufficient funds to fairly pay other creditors what they would be owed under the bankruptcy code. The FDIC has a solution to this, however. It reserves the right to clawback payments to creditors if it paid them too much.

Sounds sensible enough, but there's a problem: creditors will have to worry if some portion of the initial cashflow they received from the FDIC will be clawed back. So really, uncertainty hasn't been reduced much with regard to how creditors will be paid out. Even though they won't have to wait very long to receive money they're owed, compared to how long a bankruptcy court would take to rule, they can't be sure if they'll get to keep all of it until the entire resolution process is complete -- and that could take years too.

The Unsolved: Secured Creditors

The FDIC is humble enough to know when it's facing a tough problem. So it seeks additional comments on several issues. One has to do with payments to secured creditors.

Let's say it's October 2008. Lehman failed, but the resolution authority is in place. You're a creditor holding a secured bond that references a pool of Lehman mortgage assets. The market for those loans is extremely illiquid, so it's next to impossible to get a market price for the assets that doesn't indicate fire sale-type discounts. Should the secured creditor be forced to take a deep haircut such prices imply even if the asset's value rebounds considerably over the next year or two?

Under the FDIC's Interim Final Rule on the resolution authority, secured creditors would be provided a payout based on the value of those assets as of the day the FDIC is appointed receiver. In other words, it would probably occur at precisely the sort of time that the example above imagines.

But what's a better standard? At what point is an asset's price considered to have rebounded enough to satisfy creditors -- if it does at all? And what happens if we're talking about a pool of assets that a number of different creditors can claim a portion of? This problem is very messy.

For assets like mortgages where a security will eventually mature, then creditors can potentially be provided the option of taking a payment based on the market price at the time of receivership or waiting until the asset matures. But for assets without cash flows, the problem remains complicated. Perhaps these creditors can also be given an option for immediate payment or payment based on the asset's price after some designated time period, like two years.

Even if it is imperfect, the resolution authority is clearly a step in the right direction. It should help to avoid some panic that might have gripped the market when a giant firm is on the brink of failure. But it won't eliminate all of the uncertainty surrounding such a failure. The hope, then, must be that enough certainty is provided to the market that giant firms are no longer seen as being too big to fail. Unfortunately, it's pretty hard to know if that will be the case until we're faced with a real-world application of the FDIC's new power. At that time, the resolution authority will be put to the test.