The Federal Deposit Insurance Corporation and the Bank of England recently put out a new paper on how they might work together to aid a major financial institution that gets into trouble.
Lots of good feelings all around about international cooperation, but h aving spent the week giving the document a close read, I'm struck by how much remains unknown or simply speculative.
The basic problem is that Dodd-Frank's orderly liquidation authority as originally presented was - and still is - probably unworkable. I have written about how the fractured nature of financial institution regulation and insolvency in the United States means that in or out of the authority, failure of a big, integrated “universal bank†(or as close as we get to those in the United States) would be something of a calamity.
The F.D.I.C. has sensibly moved on, and now plans to stabilize the holding company, providing it will provide enough financing and liquidity to keep the rest of the operation afloat.
It's generally a good plan, but let's just stipulate now that whatever political party does not hold the White House will call this a bailout. So be it. I leave it to the F.D.I.C. to deal with the politics
More important, for the agency's new plan to work on a global scale, you need to make several assumptions. First, all the relevant countries have to basically agree to abstain from action, and trust that the F.D,I.C. will be able to stabilize the enterprise. Getting London on board is huge in this regard, because of the crucial role that Britain pla ys in most major American financial institutions.
There remains lost of assumptions in the paper about parties involved having “strong incentives†to behave rationally once the F.D.I.C. is standing behind the institution. One might question whether assuming that people will be rational in the kind of financial crisis we are talking about here makes a lot of sense.
But you also have to assume that the problem is not caused by a foreign subsidiary that itself has become insolvent. Rather, much of the new plan seems to turn on insolvency at the holding company level, which can be easily solved by the effects of inflicting pain on bondholders and injecting cash.
This model does not fit nicely with a foreign operating subsidiary that develops a gigantic, A.I.G.-like, cash-sucking hole. In Paragraph 37 of the new report, the regulators suggest that such a situation would require a separate, forcible equity for debt swap at the subsidiary level.
Not easy to do with the liquidation authority applying only to domestic parts of the financial institution, and doing that does seem to lead to the breakup of the institution. Creditors at the subsidiary level might not be the same creditors as at the parent level, and before you know it, one group owns the head and another the body.
The paper also talks at cross-purposes at times. On the one hand, it's quite clear that the F.D.I.C. would want to get rid of its control of the financial institution as soon as possible. Thus, the paper talks a lot about a quick turnover of new equity to old creditors.
On the other hand, it also says that as part of the resolution process, the agency might well require a significant operational restructuring of the financial institution, even to the extent of requiring a breakup of the institution. How is that going to happen if the F.D.I.C. is also giving up control right away?
The paper provides an answer: The F.D.I.C. will mandate changes that the new owners (creditors of the financial institution) will have to put into place.
Right. So, that still leaves the question of how the agency will know which changes to mandate in the short time it has control over the institution. It may also leave the creditors wondering precisely what it is that the F.D.I.C. is handing them in this process.
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
