FDIC's "Too Big to Fail" Rules Might Not Work

The Federal Deposit Insurance Corp. (FDIC) was on the frontlines of the financial crisis and remains a key figure throughout the recovery. The agency has risen to prominence in the past few years, liquidating more than 350 failed banks since 2008, overseeing the acquisitions of Wachovia and Washington Mutual and pushing for reforms under the Dodd-Frank Wall Street Reform and Consumer Protection Act--which gave the FDIC authority over larger, more complex financial organizations and seems guaranteed to remain an important presence in the financial regulatory regime.

"The FDIC is really important once every 20 years," says John Douglas, head of Davis Polk's bank regulatory practice and former general counsel of the FDIC from 1987 to 1989. "After the savings and loan crisis of the 1990s, it went back to being the supervisor of small banks in Kansas, but after this crisis it not only will supervise those small banks, it will be a more significant player in what goes on in the future. It's really gotten a substantially enhanced role in our financial sector."

Perhaps Dodd-Frank's biggest effect on the FDIC are provisions aimed at how to unwind financial companies deemed "too big to fail"--companies whose failure would destabilize the U.S. economy. Determined to avoid another chaotic Lehman Brothers or AIG situation, the FDIC's board on March 15 unanimously approved proposed rules outlining its process for creating a bridge institution, handling claims and otherwise administering a liquidation. A 60-day comment period followed.

"A lot of that [process] is not written down in regulations--much of it is practice developed over years, so this regulation is an attempt to articulate for the world how the FDIC will operate," Douglas says.

Title II of Dodd-Frank gives the FDIC orderly liquidation authority over bank holding companies, nonbank financial companies and other companies or subsidiaries the FDIC board determines to be financial in nature. The process is modeled after the agency's process for running a bank insolvency receivership.

"What they've essentially done is replicate the FDIC resolution regime [for failed banks] largely intact onto other financial companies," says Jeffrey Taft, a partner at Mayer Brown.

Rare Process

Lawyers analyzing the proposed rules say they doubt the FDIC's new authority will end the "too big to fail" problem, and institutional, political and economic circumstances will have to align before the process is used on institutions on the brink of failure. The Title II process would begin only with approval from the Treasury, the Federal Reserve, the FDIC and, in some cases, the Securities and Exchange Commission or the Federal Insurance Office. The proposed rules don't address the threshold issue of how close to default a company must be to trigger the liquidation process. And Douglas points out that the agencies still have other tools at their disposal to provide stability to a large, complicated institution--even bankruptcy, he says, could prove to be a more appropriate process.

"The bottom-line view is that politicians and other people are going to be reluctant to make hard decisions or to hold a hard line on putting large institutions into liquidation where it's going to cost jobs and have a dramatic impact," Taft says. "Even after the most recent crisis, there will always be an undercurrent that institutions will be propped up and given every benefit of the doubt before they're put into some sort of liquidation regime like Title II established."

Rigid Rules

Experts also raise concerns that the FDIC rules are too rigid, hamstringing regulators with prescribed processes whereas in the case of, for example, AIG, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson had more flexibility. Perhaps they pushed the laws to the outer limit in doing so, says attorney Ron Glancz, but they exercised their discretion in an emergency and in doing so may have saved the financial system.

"The system worked the way it should have during a crisis," says Glancz, chair of Venable's financial services group. "But Dodd-Frank does give the FDIC power and time. The goal here is to maximize the value of a company's assets, minimize its losses and mitigate risk, and the regulations do a pretty good job. The hope is they'll never have to use that because of all the other things Dodd-Frank enacted."

Missing from Title II is a process for resolution of overseas operations of a failing financial company, Taft points out. The large institutions subject to the Title II liquidation process tend to be multipronged global organizations.

"We don't really have an understanding of how liquidation will work on a global basis," Taft says. "We've seen that with some of the failures like Lehman, home countries have just grabbed what's within their borders and used those assets to pay local creditors without any regard to the larger insolvency. There needs to be some harmonization, and the first step is for each region to develop their own plans."

Down With the Ship

The FDIC has also released proposed rules under Title II that set forth a clawback process for the FDIC to recoup compensation from officers and directors with "substantial responsibility" for the distressed state of the company. Under the proposed rule, officers and directors would be presumed to have that responsibility, and the burden to prove otherwise would be on them. That doesn't sit well with financial companies or their lawyers.

"It goes too far--it gives new meaning to the old saw that the captain goes down with the ship," Glancz says. "I am concerned that the individual has to prove that he wasn't responsible for the losses."

On March 29, the FDIC and Federal Reserve released proposed rules on the Dodd-Frank requirement that financial companies regularly submit resolution plans to regulators. Often referred to as "living wills," the plans would outline how a company would handle liquidation/insolvency and would include information such as ownership structure, assets, liabilities, contractual obligations, identification of cross-guarantees tied to different securities and identification of major counterparties. While the plans may be a theoretical step in the right direction, experts question their usefulness.

"Things change so quickly," Glancz says. "Who knew Lehman was that vulnerable? It's hard to have a living will that keeps up with what's going on, and someone's not going to spend every waking hour amending the living will because the company's business plan has changed."

Associate Editor

Melissa Maleske

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