Thursday, August 15, 2013

House Financial Services Committee Hearing Examines Dodd-Frank Orderly Liquidation Authority and TBTF

Congress is not nearly done examining the contentious question of whether the Dodd-Frank Act ended too big to fail. At a hearing during the First Session of the 113th Congress held before the August recess examining Titles I and II of the Dodd-Frank Act and the attendant orderly liquidation authority for systemically important financial institutions, House Financial Services Committee Chair Jeb Hensarling (R-TX) said that there is a growing consensus that Dodd-Frank did not end too big to fail (TBTF) as applied to large, complex financial firms. Indeed, he noted that the Dodd-Frank Act codifies the TBTF doctrine. In this regard, he pointed to Section 113 of Dodd-Frank, which authorizes the Financial Stability Oversight Council to designate financial firms as systemically important financial institutions. In essence, said Chairman Hensarling, by designating a financial firm as a systemically important financial institution, the FSOC is designating the firm as TBTF.

The Committee’s Ranking Member, Rep. Maxine Waters (D-CA), noted that Title II of Dodd-Frank includes provisions that are supposed to prevent taxpayer-funded bail-outs. She pointed to Section 214(a), which provides that no taxpayer funds may be used to prevent the liquidation of any financial company under Title II. Section 214(b) requires that all funds expended in the liquidation of a covered financial company be recovered from the disposition of assets or through assessments on the financial sector. Section 214(c) provides that taxpayers shall bear no losses from the exercise of any authority under Title II.

Rep. Mick Mulvaney (R-SC) said that, despite Section 214, it appears that taxpayer funds could still be used in a Title II orderly liquidation. Asked by Rep. Mulvaney for his view, Dallas Fed President Richard Fisher noted that, if the reorganized firm cannot repay the Treasury for its debtor-in-possession financing, Section 214 says that the repayment should be clawed back via a special assessment on the company’s SIFI competitors. Since that assessment is then written off as a tax-deductible business expense by the assessed firm, thereby reducing revenue to the Treasury, Mr. Fisher contends that it is at taxpayer expense.

Rep. Patrick McHenry (R-NC) flatly stated that the Dodd-Frank Act did not end TBTF. He also noted that the FSOC has not identified new risks to the economy and the Federal Reserve Board has not made public how it would employ its new authorities to prevent a financial crisis. He also pointed out that the DOJ is reluctant to prosecute large financial institutions.

Rep. Carolyn Maloney (D-NY) emphasized that Dodd-Frank properly gave regulators a third option outside the previous binary choice for a failed financial firm of bankruptcy or a taxpayer bailout. This third option is the orderly liquidation authority in Title II, allowing the FDIC to wind down large financial firms.

Dodd-Frank and TBTF. In his testimony, Mr. Fisher argued that the Dodd–Frank Act, despite its best intentions, imposes a prohibitive cost burden on the non-TBTF financial institutions and needs to be amended. As soon as a financial institution is designated systemically important as required under Title I of Dodd–Frank, he noted, it is viewed by the market as being the first to be saved by the first responders in a financial crisis. In other words, said the Dallas Fed leader, these SIFIs occupy a privileged space in the financial system

In reality, rather than fulfill Dodd–Frank’s promise of no more taxpayer-funded bailouts, the Treasury will likely provide, through the FDIC, debtor-in-possession financing to the failed companies, he continued, thereby artificially keeping alive operating subsidiaries for up to five years, and perhaps longer. Under the single point of entry method being espoused by Treasury, the operating subsidiaries remain protected as the holding company is restructured. President Fisher described Title II of Dodd–Frank as a disguised form of taxpayer bailout that promotes and sustains an unnatural longevity for zombie financial institutions.

Dallas Fed Reform Proposal. The Dallas Fed has a three-prong reform proposal to address the situation. First,  roll back the federal safety net of deposit insurance and the Federal Reserve’s discount window to where it was always intended to be, that is, to traditional commercial bank deposit and lending intermediation and payment system functions. Thus, the safety net would only be available to traditional commercial banks and not to the nonbank affiliates of bank holding companies or the parent companies themselves.

Second, customers, creditors and counterparties of all nonbank affiliates and the parent holding companies would sign a simple, legally binding, unambiguous disclosure acknowledging and accepting that there is no government guarantee backstopping their investment. Third, the largest financial holding companies would be restructured so that every one of their corporate entities is subject to a speedy bankruptcy process.

Former FDIC Chair Bair. In her testimony, former FDIC Chair Shelia Bair strongly disagreed with the notion that Title II’s orderly liquidation authority enshrines the government bailout policies of 2008 and 2009. Dodd-Frank has abolished the implicit and explicit TBTF policies that were in effect before its enactment. To the extent that TBTF remains, she noted, it is because regulators have more work to do to ensure that financial firms go into orderly liquidation if they do fail and because markets continue to question whether government will follow through on Title II and allow a systemically important firm to fail.

There are some things that could be done to improve the orderly liquidation process, said the former FDIC Chair. For example, regulators should ensure that large, complex financial institutions have sufficient long-term debt at the holding company level. The success of an orderly liquidation authority using the Treasury’s single point of entry approach depends on the top level holding company’s ability to absorb losses and fund recapitalization of the surviving operating entities,   reasoned the former FDIC head. Currently, nothing requires that firms hold sufficient senior debt to meet this need.

FDIC Vice Chair Hoenig. In his testimony, FDIC Vice Chair Thomas Hoenig expressed concern that government support of large financial institutions, combined with their outsized impact on the broader economy, gives them important advantages and encourages them to take on ever-greater degrees of risk. Short-term depositors and creditors continue to look to governments to assure repayment, he noted, rather than to the strength of the firms' balance sheets and capital. As a result, these companies are able to borrow more at lower costs than they otherwise could, and thus they are able increase their leverage far beyond what the market would otherwise permit. Their relative lower cost of capital also enables them to price their products more favorably than firms outside of the safety net can do. These advantages translate into a subsidy that represents a sizable competitive advantage and which leads to a more concentrated industry.

The FDIC official noted that the Dodd-Frank Act was intended to address the build-up of systemic risk and, if necessary, the management of its fallout on the economy. However, there remain systemically important financial firms that are of a size and complexity that would expose the broader economy to overwhelming consequences should they encounter problems. The Dodd-Frank Act does not change the fundamental incentive of the safety net's subsidy, he said, which continues to encourage these firms to leverage and take on excessive risk for higher returns. As long as the subsidy exists, there will be highly leveraged, highly vulnerable institutions that will negatively impact the national economy.