A Plan to Perpetuate the Big Banks, While Liquidating Small Ones

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February 1 is the deadline for public comments on the last piece in the government's plan to end the "too-big-to-fail" problem. When the Federal Reserve's Total Loss-Absorbing Capacity (TLAC) regulation is finalized, half of the US banking system will be subject to a new and untried resolution scheme that is designed to keep the largest banks open and operating while, at the same time, smaller banks continue to be closed and liquidated. Rather than end "too-big-to-fail" (TBTF), this plan ensures the survival and growth of TBTF institutions and sets the stage for future taxpayer bailouts.

The Orderly Liquidation Authority provision - Title II of Dodd-Frank - was supposed to end TBTF by creating a new mechanism for liquidating TBTF institutions outside of bankruptcy. Dodd-Frank gave the Federal Deposit Insurance Corporation and the Federal Reserve Board new liquidation duties and powers, but did not specify how a Title II liquidation would work, or how it would end too-big-to-fail. These details were delegated to regulators. TLAC is the final rule needed for the regulators' Title II plan.

The latest regulation will require the parent companies that own too-big-to-fail banks to issue debt to absorb losses in a Title II resolution. To avoid a financial meltdown, regulators have decided that all too-big-to-fail banks must be kept open, operating, and protected from failure. Under the regulators' plan, the equity and TLAC debt of parent companies will be used to guarantee all of the liabilities of the TBTF banks to prevent them from ever failing. If you lend to a TBTF bank, as long as you have not bought its parent company's TLAC debt, regulators plan to protect you against loss.

Should a TBTF bank suffer a potentially terminal loss, the regulators will use Title II powers to take the parent company into receivership, and use its resources to recapitalize the bank and all of the systemically important operating subsidiaries owned by the TBTF parent company.

According to my calculations, if TLAC were in place today, the parent institutions of TBTF banks would have to maintain about $573 billion in total outstanding TLAC debt. In return, they would receive new government protection for about $7 trillion of uninsured liabilities issued by their subsidiaries. For every $1 of TLAC debt, the TBTF consolidated group will gain new protection on $12 of their subsidiaries' liabilities. The interest on TLAC bonds fully accrues to private investors so the government earns nothing for extending new default protection on $7 trillion of TBTF subsidiary liabilities.

Proponents argue that TLAC bond investors will charge TBTF parent companies a risk premium for the Title II resolution losses the bond holders are supposed to absorb. This premium is supposed to eliminate the interest rate subsidy currently enjoyed by TBTF institutions. If this works as planned - and it's a big if -shareholders and TLAC investors in TBTF parent companies will provide the insurance for the $7 trillion subsidiary liabilities that are currently not protected.

But can you remember the last time a government policy worked exactly as planned? Indeed, if events don't unfold exactly as regulators have planned, taxpayers may again be forced to bailout the largest financial institutions.

There are many potential bailout scenarios. For one, Title II is not a sure option. Title II powers can only be used when the TBTF parent company is in danger of default and its bankruptcy would cause a financial market crisis. If the parent is not in danger of default, Title II is unavailable, and regulators cannot use the assets of the parent company or its TLAC debt to guarantee the debts of the subsidiaries.

What happens if Tile II cannot be used? Regulators could renege on the protections they have promised or else scramble to devise a "plan B" to raise funds to recapitalize the bank or other critical subsidiary. It is disturbing that the Fed's TLAC proposal has no discussion of this important issue. The regulators just assume that Title II will be available.

A more unsettling scenario is a repeat of the last financial crisis where multiple TBTF institutions are simultaneously in danger of default. It is incredible to think that the government would put multiple institutions, which comprise 15-to-30 percent or more of the banking system's total assets, under direct government control in Title II receiverships. More realistically, authorities would again argue for a "TARP-like" bailout. In a crisis with multiple TBTF institutions at risk, it will be all but impossible to use the regulators' Title II liquidation plan.

Fortunately - and unfortunately - it will take years before we know whether the regulators' plan will work. In the meantime, the owners of TBTF institutions will benefit from the plan's $7 trillion new government guarantees. And years from now, if events go awry, regulators may again be faced with an old conundrum: should they let TBTF banks fail and impose losses on the creditors who thought they were protected by the regulators' Title II orderly liquidation plan - which could spark a crisis - or should they use taxpayer support to recapitalize failing TBTF institutions.

Ironically, regulators have used new Dodd-Frank powers to develop an "orderly liquidation" plan that is designed to save the largest too-big-to-fail banks while small institutions continue to fail. The regulators' Title II plans do not end TBTF, but instead inadvertently insure that community banks will continue to disappear as the banking system consolidates into a few large protected institutions.

Paul Kupiec is a resident scholar at the American Enterprise Institute where he studies banking and financial sector regulation.  

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