Risk Management

How to Avoid Bank Bailouts

CFOs and treasurers who do business with the biggest banks, insurers, and hedge funds may find it comforting if sputtering ones are red-flagged.
Marie LeoneJuly 24, 2009

The last time the Obama Administration labeled financial-services firms too big to fail, the result was government handouts to prop up sputtering giants like Bear Stearns, Morgan Stanley, and AIG. The latest proposal from President Obama, which he sent to Congress on Wednesday, takes a different approach. Under the plan, if a financial institution runs into trouble and is classified as too big, too complex, and too interconnected with other financial institutions to fail, the government will unwind it and shut it down in what it deems an orderly fashion.

Corporate CFOs and treasurers who do business with the largest banks, insurers, and hedge funds may find that having red flags on those that are in trouble is comforting. Knowing in advance that your financial-services provider might fail would likely be preferable, for example, to the precipitous collapse of Lehman Brothers last fall. An early warning system would help pump up investor and counterparty confidence as well. To be sure, the devil is in the details. But the details are harder to come by than a Republican endorsement of the President’s plan.

Indeed, at a hearing held by the Senate Banking Committee Thursday, most lawmakers were anxious to unearth very basic details: how regulators will define “systemic risk,” how they will determine which companies fall into that category, and what powers regulators should have to deal with these troubled behemoths. But the regulators who testified — Sheila Bair, chairman of the Federal Deposit Insurance Corp.; Daniel Tarullo, a Federal Reserve Board governor; and Mary Schapiro, chairman of the Securities and Exchange Commission — sent the ball back into the senators’ court, saying, essentially, that only Congress can rework the law and establish the necessary guidelines.

Nevertheless, the regulators provided Congress with key concepts that should give lawmakers a start. Under the Obama proposal, any institution that’s determined to pose a systemic financial risk to the United States should be shut down to eliminate any potential domino effect, said Bair.

“The notion of too big to fail creates a vicious circle that needs to be broken,” asserted Bair, who said the shutdown, or “resolution mechanism,” would be similar to a typical Chapter 11 bankruptcy in that the associated losses would be borne by the stockholders and bondholders of the affected company. Senior management would be replaced.

Bair2Bair, Schapiro, and Tarullo testify before the Senate Banking Committee on Thursday.

To further contain the damage, Bair advocated a new rule that would require bank holding companies with subsidiaries engaged in nonbanking financial activities to file a resolution plan with the FDIC that would be updated annually and disclosed to market participants and customers. As another precaution, the largest, most complex financial-services companies — those most likely to pose a systemic risk — would be heavily regulated by the Federal Reserve, and have to submit to a significant amount of stress testing.

In his testimony, Tarullo cautioned lawmakers that shuttering a financial institution in the proposed way should be a rare occurrence. “Chapter 11 is the appropriate route” for unwinding financial and nonfinancial companies. The new regime “should be a discrete mechanism used in unique situations,” he noted.

Senators including Republicans Richard Shelby of Alabama, Robert Corker of Tennessee, and Michael Johanns of Nebraska prodded the regulators for risk criteria that would help classify companies as too big to fail. The regulators suggested a combination of factors, including value of assets, level of transparency into unregulated and off-balance-sheet transactions, and degree of interconnections with other institutions.

The regulators favored setting up a regime that is self-policed and thereby uses “business disincentives” to sour companies on growing too big. “We think any designation as a systemic risk should be a bad thing, not a good thing,” contended Bair. As has been the case in the current crisis, big financial institutions “can basically blackmail us because of [the threat of] a disorderly resolution…. It rewards them for being very large and complex.”

Bair believes that with the help of Congress, regulators can change the behavior within financial institutions by turning the “too big to fail” moniker into a stigma, rather than a guarantee of a government bailout. To do that, she is looking for Congress to pass laws that, for example, give the FDIC a receivership role once the regulator decides to shutter an institution; allow regulators to collect fees from big, complex institutions to prefund the working capital needs of a shutdown; require larger capital and liquidity buffers for institutions that pose greater systemic risk; and mandate restrictions on leverage and risk-based premiums levied on riskier institutions.

The senators and regulators agreed, in theory, on several points. Both groups said that final rules should avoid bright-line criteria, especially regarding how to classify companies as being systemic risks. Bright-line rules, they reasoned, would only encourage executives to manage around the criteria, while still posing significant systemwide risks.

Both groups also questioned President Obama’s idea of anointing the Federal Reserve as the single systemic risk regulator and establishing a Financial Services Oversight Council to coordinate financial regulatory efforts. The panel and senators took a different approach, saying they would favor handing over regulatory power to the council, which would be headed by Treasury and comprise representatives from the Fed, FDIC, SEC, and other agencies with oversight of the financial markets. In this capacity, the aim of the council would be to bring different perspectives to the table so a “holistic” view of risks could be identified and dealt with before the problems triggered a crisis. For instance, the Federal Reserve could focus on maintaining the safety and soundness of financial institutions, while the SEC would stay trained on investor protection.

Based on the testimonies of the panelists, the council’s purview would include decision-making and rule-making related to excessive leverage, inadequate capital, overreliance on short-term capital, overdependence on counterparties, and whether institutions should venture into such risky activities as proprietary trading and hedge-fund trading. In some ways, the new council would be similar to the U.K.’s Financial Services Authority, which is appointed by the British Treasury Department and has broad powers to issue and enforce rules, and to investigate questionable conduct for the entire financial marketplace.

Asked if it’s possible for regulators to keep up with, or “outsmart,” Wall Street as it develops new products and dreams up ever-more-complex transactions, Schapiro quipped: “I think this time, Wall Street outsmarted itself, not just the regulators.”