With many institutions still designated as "systemically important" or "too big to fail" even seven years after the financial crisis, a subcommittee of the Senate Banking Committee convened for a hearing on Wednesday to discuss ways in which bankruptcy reform could end "too big to fail" and get taxpayers off the hook for keeping large financial institutions alive.
Witnesses at the Subcommittee on Financial Institutions and Consumer Protection's hearing included Randall D. Guynn, Partner with Davis Polk & Wardell; Professor John B. Taylor, Hoover Institution Senior Fellow in Economics at Stanford University; Professor Thomas H. Jackson, President Emeritus of the University of Rochester; and Professor Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan School of Management.
Guynn suggested a "single point of entry" strategy in which the top-tier parent of a U.S. banking group would be placed in a special resolution proceeding under Dodd-Frank's Title II or Chapter 11 bankruptcy. A new financial holding company, called a "bridge FHC" (because it is a bridge to exit from receivership or bankruptcy") would be established by the FDIC under Dodd-Frank or the debtor-in-possession in Chapter 11 bankruptcy. All of the assets of the failed parent of the banking group would then be transferred to the bridge FHC, including ownership interests in operating subsidies.
"This would be done in a bankruptcy proceeding, with court approval, pursuant to Section 363 of the Bankruptcy Code," Guynn said. "All of the shares and long-term unsecured debt of the failed parent would remain behind in the receivership or bankruptcy proceeding. Only a limited amount of critical operating liabilities, such as those to the electric company or critical vendors as well as parent guarantees, would be assumed by the bridge FHC, making it essentially debt-free."
Taylor noted there are two current bills in Congress—one in the House (the Financial Institution Bankruptcy Act of 2015) and one in the Senate (the Taxpayer Protection and Responsible Resolution Act), which he called "essential" for ending government bailouts.
"Such a reform—which would make failure feasible even for large and complex financial institutions—would play a key role in addressing the problems of excess risk taking, uncertainty, and unfair subsidies associated with too big to fail, which persist under the Dodd Frank Act," Taylor said. "If accompanied with an increase in capital and capital structure debt, such a reform would go a long way toward ending too big to fail."
Jackson said he believed that Title II of Dodd-Frank should play a limited role in bankruptcy reform, and that use of the single point of entry strategy under Title II would be subject to criticism and investigation. Instead, he said, "modest amendments" to the bankruptcy code are all that is needed to end the bailouts.
"Through modest amendments to the Bankruptcy Code, expressly enabling it to effectuate a rapid two-step recapitalization from a SIFI holding company to a bridge company (by leaving long term unsecured debt behind), it indeed can be considered the primary resolution vehicle for SIFIs (systemically important financial institutions), as envisioned by the Dodd-Frank Act, limiting the role of Title II—and therefore administrative-based resolution—to the cases, that almost inevitably may occur, where we cannot contemplate today the causes or contours of the next crisis, so that the FDIC’s inevitable discretion, compared to a judicial proceeding, becomes a virtue rather than a concern," Jackson said.
According to Johnson, the solution would be to eliminate so-called large financial institutions and make them all small enough so that their failure, or bankruptcy, would not adversely affect the rest of the country's financial sector. He cited failures of CIT Group in 2009 and MF Global in 2011 as "encouraging examples."
"But the balance sheets of these institutions were much smaller—about $80 billion and $40 billion, respectively—than those of the financial firms currently regarded as too big to fail," Johnson said. "To the extent that the authorities are unwilling or unable to make some banks smaller and simpler, they should substantially increase the required amount of loss-absorbing equity for those firms. Concerns about complexities associated with the failure of cross-border operations also strengthen the case for higher capital requirements (in the form of loss-absorbing equity, not an illusory TLAC requirement)."