Daniel K Tarullo: Toward building a more effective resolution regime -
progress and challenges
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Board and Federal Reserve Bank of Richmond Conference,
"Planning for the orderly resolution of a global systemically important bank", Washington DC,
18 October 2013.
* * *
Observing the five-year anniversaries of various key moments in the financial crisis
throughout 2013 cannot but prompt us to step back and evaluate the effectiveness of the
regulatory reform efforts that followed. This week, which marks five years since the U.S.
government launched the Troubled Asset Relief Program (TARP), is a particularly
appropriate moment to hold this conference on the resolution of systemically important
financial institutions (SIFIs). The TARP's extension of unprecedented capital support to many
of the largest U.S. banks reflected the view of government officials that the failure of these
firms would have posed a grave threat to the financial system. The turmoil that followed the
failure of Lehman and the decision to rescue AIG each, in their way, underscored the
absence of a third alternative to the options of bailout or disruptive bankruptcy. The creation
of such an alternative, included as the Orderly Liquidation Authority in Title II of the
DoddFrank Wall Street Reform and Consumer Protection Act, was a key part of the reforms.
In fact, the emergence of a growing consensus around the key elements of a credible
resolution mechanism, and the work to engraft those elements into appropriate statutory and
administrative frameworks, is one of the more unheralded - if still in progress - successes of
the post-crisis regulatory response. Here in the United States, the Federal Deposit Insurance
Corporation (FDIC) has been doing path-breaking work to build out the statutory provisions
of the Dodd-Frank orderly liquidation authority. Internationally, the Financial Stability Board
(FSB) has elaborated a set of principles to guide the development of resolution mechanisms
globally.1 And, throughout both processes, there has been fruitful interaction among the
official sector, academics, and market participants.
In my remarks this afternoon, I will begin by explaining the purpose and critical features of a
special mechanism for resolving large financial firms, especially those of systemic
importance. Next, I will explain why the efforts of the FDIC have been so important in
developing credibility for the Title II resolution mechanism for systemically important firms
and identify some of the important work that remains, not just for the FDIC, but for a range of
official sector and private actors, here and abroad. Finally, I will end with a few thoughts on
the relationship between resolution mechanisms and the broader regulatory reform agenda
we have been pursuing over the past several years.
The purpose and critical features of a special resolution mechanism
The crisis, and the scope of government support for large banks that it precipitated, spawned
an ambitious international regulatory reform agenda directed at the financial stability risks
posed by SIFIs. It was recognized that, left unaddressed, the necessary but unpalatable
government interventions during the crisis would only further entrench the too-big-to-fail
status of systemic financial firms - increasing moral hazard, undermining market discipline,
and harming competitive equality among financial institutions of different sizes.
Stated most pointedly, then, the purpose of a special resolution mechanism for large financial
firms is to prevent future situations in which government officials face the unappealing choice
they confronted in 2008, to which I alluded a moment ago. Stated more analytically, a special
resolution mechanism is needed to take account of the characteristics of financial markets,
and of larger firms operating in those markets, that do not fit easily with normal bankruptcy
practice. These characteristics all relate to a basic function of financial intermediaries in
providing liquidity to firms and households - whether through maturity transformation, by
which banks allow depositors to lend out their savings while maintaining complete liquidity;
through market-making, by which dealers provide liquidity to investors in various instruments;
or through other forms of intermediation.2
Precisely because financial intermediaries provide these liquidity services, they are subject to
funding strains when customers or counterparties become uncertain of the value of the
loans, securities, or other assets held by the intermediaries. Where those assets are opaque
- as can be the case, for example, with a portfolio of conventional loans or with securities
backed by many loans bundled together from various originators - the incentive to withdraw
funding increases, particularly in periods of stress when the value of broadly held asset
classes may be at risk of precipitous decline.
This familiar dynamic is obviously a potential problem for the intermediary. It becomes a
problem for society when one or both of two things follow: First, as in the classic case of
bank runs, problems at one bank lead depositors or counterparties at other banks to
withdraw their own funds, fearing that their own banks may have similar difficulties repaying
them because they hold similar assets. Or, second, the liquidity squeeze leads a sizeable
financial firm to engage in a fire sale of its assets in order to raise the funds necessary to
compensate for the disruption of its normal funding channels. Dumping a sizeable book of
assets on the market, in turn, can lead to the adverse feedback loop observed during the
crisis: Downward pressure is placed on similar assets held by others, thereby accelerating
margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the
assets, thereby prompting fire sales by others. In either or both of these eventualities, the
potential insolvency of the financial firm is a problem not just for shareholders, employees,
and creditors, but for the financial system as a whole.
A final point is that a financial firm, through the operation of one or both of these dynamics,
can shift from viable to non-viable in quite a short period of time. And, once the confidence of
counterparties and customers is shaken, and funding withdrawn, the game is essentially
over. Of course, matters are made worse if the firm did not maintain adequate capital levels
or relied too heavily on short-term funding, as was the case with many of the firms that failed
or came under severe pressure in 2008. However, it is important to note that the nature of
financial intermediaries means that even firms compliant with more rigorous capital and
liquidity requirements could be faced with these dynamics in a tail event.
To be credible, then, a resolution mechanism for large financial firms must be capable of
dealing with these characteristics of financial markets. This is the premise underlying Title II
of Dodd-Frank, and I think it has also been the premise of thoughtful commentators who
have proposed amendments to the Bankruptcy Code for application to large financial firms.3
There are three key features of Title II and, modified in certain respects, some of these
Bankruptcy Code proposals reflect recognition of the peculiarities of financial markets in a
way the current Bankruptcy Code does not.
The first key feature of Title II, simply put, is speed. It is vital that a resolving authority be able
to move very quickly from non-resolution to resolution status, while maintaining continuity of
operations. As many of you will recall, during the financial crisis the makeshift arrangements
crafted by governments in an effort to avoid large negative effects on financial markets were
usually completed over a weekend.
The second key feature is a source of immediate funding to continue essential functions and
minimize the kind of fire sales referred to earlier. The Bankruptcy Code allows for so-called
debtor-in-possession (DIP) financing to be provided to any firm going through the bankruptcy
process.4 Such DIP financing is often essential to maximize the going-concern value of the
firm. For a failed SIFI, such funding may be required quickly and in fairly large sums - needs
that may not be fully met by private lenders, at least not in the immediate aftermath of a firm
being placed into the Title II process.
For these reasons, funding from the FDIC, drawing on a line from Treasury, is available
under Title II. It is important to note, though, that the underlying concept has the same roots
as DIP financing - lending that will maintain or increase the going-concern value of the firm,
not absorb losses. It is not a capital injection and does not put taxpayers at risk. The FDIC
has indicated that it will, in order to protect taxpayers more fully, require that the financing be
collateralized and if, for any reason, the FDIC cannot recover the full amount of credit
extended, the shortfall is to be made up by a tax on other large financial firms.
The third necessary feature is a temporary stay of close-out rights of qualified financial
contract counterparties. The ability of the FDIC, subject to important creditor safeguards, to
nullify the direct- and cross-default rights of counterparties can halt the disruptive,
uncertainty-driven race to seize and liquidate a firm's assets immediately upon its entrance
into a Title II resolution. The FDIC authority includes the opportunity to decide whether it
wants to transfer qualified financial contracts (QFCs) to a bridge financial company or
another solvent company during a one-day statutory stay of the contractual rights of
counterparties of the firm being resolved. As I will discuss later, this authority is not without
limitations, particularly in a cross-border resolution, but it is a critical tool for an effective
resolution of a financial firm with complex portfolios of financial contracts.
While Title II establishes a special resolution mechanism and grants the FDIC powers
responsive to the special challenges posed by the failure of large financial institutions, it
provides only a legal framework, not an elaborated description of how these powers would
be used to resolve a systemically important financial firm. Moreover, the very large financial
firms that are the most likely subjects of a Title II proceeding have extensive cross-border
activities, and thus implicate the legal systems of other countries. Thus, for orderly liquidation
authority to be effective in containing too-big-to-fail concerns and supporting financial
stability, the statutory provisions must be supplemented with administrative planning by the
FDIC and with consistent measures in other jurisdictions.
Developing a clear, credible approach to resolution
It is important to develop and articulate a credible approach to such a resolution proceeding,
for at least two reasons. First, unless creditors and counterparties have well-grounded
expectations as to how they will be treated in a resolution setting, they may need to charge a
premium to compensate for the additional uncertainty associated with the disposition of their
claims, which can lead to a mispricing of risks. In some cases, particularly in periods of
increasing stress in the financial system, they may be unwilling to deal with certain firms
altogether. Parties who have short-term lending to, or contractual arrangements with, these
firms may "run" as those loans or contracts lapse, thereby potentially crippling the ongoing
business of the firm and creating adverse effects in other parts of the financial system.
A second reason is, in some sense, the converse of the first. If creditors and counterparties
do not believe the FDIC can successfully resolve the firm, they may not price in the potential
for losses that should be incorporated in their dealings with large firms. That is, if investors
and other market actors think the prospects for orderly resolution seem low, they may
assume the firm will be rescued by the government, and any moral hazard present in these
markets will continue. By specifying which financial obligations will be maintained and where
the FDIC will look to impose losses, a well-developed approach to resolution can create
incentives for private action compatible with the overall aims of systemic firm resolution.
The FDIC has made great progress in implementing Title II, in particular by developing the
single-point-of-entry approach to resolution of a systemic financial firm. Under the
singlepoint-of-entry approach, the FDIC will be appointed receiver of only the top-tier parent
holding company of the failed firm. After the parent holding company is placed into
receivership, the FDIC will transfer assets of the parent company to a bridge holding
company. The firm's operating subsidiaries (foreign and domestic) will remain open for
business as usual. To the extent necessary, the FDIC will then use available parent holding
company assets to recapitalize the firm's critical operating subsidiaries. Equity claims of the
failed parent company's shareholders will effectively be wiped out, and claims of its
unsecured debtholders will be written down as necessary to reflect any losses or other
resolution costs in the receivership. The FDIC will ultimately exchange the remaining claims
of unsecured creditors of the parent for equity or debt claims of the bridge holding company
and return the restructured firm back to private sector control.
This conceptual approach to resolution under Title II represents an important step toward
ending the market perception that any U.S. financial firm is too big or too complex to be
allowed to fail.5 The aim of the single-point-of-entry approach is to stabilize the failed firm
quickly, in order to mitigate the negative impact on the U.S. financial system, and to do so
without supporting the firm's equity holders and other capital liabilities holders or exposing
U.S. taxpayers to losses. The single-point-of-entry approach offers the best potential for the
orderly resolution of a systemic financial firm under Title II, in part because of its potential to
mitigate run risks and credibly impose losses on parent holding company creditors and,
thereby, to enhance market discipline.
In the United States, the top-tier parent company of a large banking firm generally is not an
operating company but a holding company, whose primary purpose is to raise capital and
direct the operations of its subsidiaries. Its assets largely consist of cash, liquid securities,
and equity and debt interests in its subsidiaries. This common organizational feature of U.S.
banking firms facilitates the single-point-of-entry approach because the liabilities of the
toptier holding company are structurally subordinated to the customer obligations and other
direct liabilities at the firm's operating subsidiaries. Accordingly, under the single-
point-of-entry approach, the equity and debt at the holding company level can form a buffer
that must first be exhausted before any customer or creditor of a subsidiary suffers losses.
The existence of this buffer should help give the customers and creditors of a U.S. banking
firm greater clarity regarding their potential loss exposure in failure. The presumption that
holding company capital liabilities would be required in the first instance to absorb losses in a
systemic financial firm will be critical in maintaining the confidence, and limiting the run
potential, of customers, liquidity providers, and other creditors at the operating subsidiary
level.
The single-point-of-entry approach does not involve a government guarantee that subsidizes
systemic financial firms by protecting their investors from downside risk. The resolution would
result in a recapitalization of a failed firm by the firm's own investors. Any protection received
by the creditors of a failed firm's operating subsidiaries would be provided by the equity and
debt holders of the failed firm's parent holding company. And even if any temporary losses
were suffered by the government because of its provision of liquidity, Dodd-Frank requires
that the government be reimbursed through assessments on large financial firms.
The work being done by the FDIC in building out its approach to Title II will continue, and the
FDIC has indicated that it will explain this thinking in further detail in a public release later this
year. In addition to the FDIC's work, there are other ways that the credibility of Title II can be
enhanced. For example, the Federal Reserve and the FDIC can use their joint responsibility
for overseeing the resolution plans, which are required by Dodd-Frank, for large, prudentially
regulated firms to improve the resolvability of systemically important financial institutions.6
The largest U.S. bank holding companies and foreign banking organizations submitted their
first annual resolution plans to the Federal Reserve and the FDIC in 2012 and have recently
submitted a second round of resolution plans. These plans have yielded valuable information
that is being used to identify, assess, and mitigate key challenges to resolvability under the
U.S. Bankruptcy Code and to support the FDIC's development of backup resolution plans
under Title II. We expect the second round of submissions to include improvements that
address the initial set of obstacles to resolvability identified during the first round.
More broadly, our evaluation of the resolvability of these large firms has been further
advanced by the resolution planning process. Let me mention two ways in which the
organizational structure of systemic financial firms could be shaped so as to facilitate the
single-point-of-entry approach. One would be to ensure that losses at material operating
subsidiaries, including in material foreign subsidiaries, could be transferred to the parent
holding company in resolution. The other would be to keep the firm's parent holding company
non-operational and otherwise "clean" through limits on the issuance of short-term debt and
on the conduct of material business operations in the parent holding company. The
singlepoint-of-entry approach concentrates losses on the creditors and counterparties of the SIFI
parent, as opposed to the operating subsidiaries. Accordingly, the impending failure of a SIFI
would create strong incentives for creditors and counterparties of the parent holding
6
Dodd-Frank Section 165(d), 12 U.S.C. §5365(d). Resolution plans are also required of non-bank financial
firms designated by the Financial Stability Oversight Council as of systemic importance and thereby subject to
supervision by the Federal Reserve. These plans are also useful supervisory tools that have helped the
Federal Reserve and the firms focus on opportunities to simplify corporate structures and improve
management systems in ways that will help the firms be more resilient and efficient, as well as easier to
resolve. Earlier this year, the Federal Reserve issued supervisory guidance relating to operational resilience,
including supervisory expectations regarding collateral management; payment, clearing, and settlement
activities; liquidity and funding; management information systems; and shared and outsourced services. This
guidance was informed by the cross-firm comparative review of the first round of resolution plans and reflected
initial supervisory judgments of those practices and capabilities necessary to support effective recovery and
resolution planning efforts. Going forward, supervisory assessments will require firms to demonstrate their
capabilities in these areas. The resolution planning process has been designed to be iterative; there is still
much work to be done in this area by firms, domestic and foreign supervisors, and national governments.
company to run.7 The single-point-of-entry strategy will be more credible and effective if the
only creditors of the parent holding company are holders of capital instruments, and
longterm debt holders are fully aware they are subject to bail-in as part of any Title II resolution.
Another way to enhance the credibility of the FDIC's approach is to require adequate
lossabsorbing capacity within large financial firms. Minimum capital requirements, conceptually,
are designed to cover losses up to a certain statistical probability. If an extreme tail event
occurs and the equity of the firm is wiped out, successful resolution without taxpayer
assistance would be most effectively accomplished if a firm had sufficient long-term,
unsecured debt to absorb additional losses and to recapitalize the business transferred to the
bridge operating company. The presence of this debt explicitly identified for possible bail-in
on a "gone concern" basis should help other creditors clarify their positions in the orderly
liquidation process. A requirement for long-term debt could also have the benefit of improving
market discipline, since holders of that debt would know they faced the prospect of loss
should the firm enter resolution and would presumably demand an appropriate risk premium.
The Federal Reserve, in consultation with the FDIC, will be issuing in the next few months a
proposal that would require the largest, most complex banking firms to hold minimum
amounts of long-term, unsecured debt at the holding company level. This requirement will
have the effect of preventing erosion of the current long-term debt holdings of the largest,
most complex U.S. firms, which, by historical standards, are currently at fairly high levels.
Absent a minimum requirement of this sort, one could expect declines in these levels as the
quite flat yield curve of recent years steepens; indeed, we have recently seen some evidence
of the beginnings of such declines. At the international level, the FSB has recently
announced that it will be issuing proposals for global standards on gone-concern loss
absorbency for global systemically important financial institutions.8
The single-point-of-entry approach will also be facilitated by the presence of a sufficient
amount of assets of the right types at the SIFI parent to enable the recapitalization of its
material operating subsidiaries when losses have eroded the capital of the subsidiaries. The
write-down of equity and the imposition of haircuts on parent holding company debt in Title II
does not by itself recapitalize the operating subsidiaries. Moreover, foreign operations of a
SIFI are more likely to be ring-fenced or wound down separately under the insolvency laws of
their host countries if foreign authorities or directors do not have full confidence that local
interests would be protected. A requirement that a SIFI's parent holding company hold
minimum amounts of "internal bail-in" debt issued by its material operating subsidiaries could
offer a solution to this problem: A failed SIFI parent holding company would be able to inject
capital into its material operating subsidiaries by effectively converting that intra-group debt
into equity.
Cross-border issues
In many ways, Title II has become a model resolution regime for the international community.
In 2011, the FSB adopted the Key Attributes of Effective Resolution Regimes for Financial
Institutions, a new standard for resolution regimes for systemic firms.9 The core features of
this global standard were already embodied in Title II. By acting early, through the passage
of the Dodd-Frank Act, the United States led the way in shaping the development of
international policy for effective resolution regimes for systemic financial firms. The FDIC's
work on the single-point-of-entry approach continues to help frame the terms of international
discussions at the FSB. Moreover, as the home-country supervisor of eight of the 28 global
systemically important banks (G-SIBs) identified by the FSB, the Federal Reserve has
responsibility for establishing and routinely convening for each U.S. G-SIB a crisis
management group.10 These firm-specific crisis management groups, which are comprised
primarily of the firm's prudential supervisors and resolution authorities in the United States
and key foreign jurisdictions, are working to mitigate potential cross-border obstacles to an
orderly resolution of the firms.
All that said, many other major jurisdictions have not yet enacted legislation that would create
a statutory resolution regime with the powers and safeguards necessary to meet the FSB's
Key Attributes. Mitigating the obstacles to SIFI resolution will require, at a minimum, that key
Key
foreign jurisdictions implement national resolution regimes consistent with the Attributes.
While compatible host-country resolution regimes are necessary for orderly cross-border
resolutions, they may not be sufficient. Most importantly, home-country resolution of a global
systemic financial firm may be nearly as difficult if creditors and counterparties of the firm's
foreign operations run as will likely happen if domestic creditors and counterparties do so.
Possibilities for such runs may be reduced by well-developed and transparent arrangements
for cooperation between home- and host-country officials in resolving these firms. The recent
joint paper by the FDIC and Bank of England is an important example of such cooperation.11
But, standing alone, even the best of cooperative arrangements may not remove all salient
obstacles.
One key challenge is that certain Title II stabilization mechanisms, including the one-day stay
provision with respect to over-the-counter derivatives and certain other financial contracts,
may not apply outside the United States. Accordingly, counterparties to financial contracts
with the foreign subsidiaries and branches of a U.S. firm may have contractual rights and
substantial economic incentives to terminate their transactions as soon as the U.S. parent
enters into resolution. Equivalent opportunities and incentives may apply to counterparties of
U.S. operations of foreign banking organizations.
One approach to addressing this problem would be for domestic legislatures to amend
bankruptcy and insolvency laws to recognize stays imposed in home-country resolution
procedures consistent with international standards. However, it may be difficult to get such
legal changes on roughly comparable terms in all relevant jurisdictions, much less to
conclude a binding international agreement along those lines.
A second approach, currently under consideration by regulators, would be to seek
modifications to standard contractual cross-default, netting, and related practices. This
approach would use contractual measures to achieve the same end of having these
arrangements effectively governed by resolution decisions in home countries. Of course,
even if agreement were reached among regulators, in consultation with relevant industry
associations, and effective steps were taken to implement that agreement, it could take some
time for the new terms to be widely adopted in relevant markets. But a regulatory timeline
could be set to speed up the process. This approach may be the most promising for tackling
this vexing problem.
Resolution and regulation
The resolution mechanism created by Title II of Dodd-Frank is gaining greater operational
credibility as the FDIC builds out its single-point-of-entry approach. With each rule, policy
statement, cross-border agreement, and firm-specific resolution plan, that credibility is further
increased. Additional measures such as those I have suggested today will continue to
enhance this third option of orderly resolution, and relieve government officials of the
Hobson's choice of bailout or disruptive bankruptcy for systemically important financial firms.
However, as is apparent from the amount of work and planning involved in this effort
- particularly, though not exclusively, on cross-border matters - the construction of a
resolution framework remains an ongoing challenge. Moreover, even when a large, complex
firm can be resolved at no cost to taxpayers without provoking a systemic crisis, there will
very likely still be significant negative externalities in the financial system. That is, even if a
firm is not too-big-to-fail, it may still be of sufficient systemic importance to make its failure a
costly event.
Thus, even as policymakers strive to increase prospects for orderly resolution, we must
continue efforts to reduce prospects for the failure of a systemically important firm that would
require this special mechanism. Stronger capital and liquidity requirements that improve
going-concern resiliency will remain crucial to a reform agenda directed at containing the
toobig-to-fail problem. The objectives of preventing failure and of reducing systemic costs in the
event failure nonetheless occurs are complementary, rather than alternative, policy aims.
The most important systemic vulnerabilities that have not been subject to sufficient regulatory
reforms are those created in short-term wholesale funding markets. In the recent financial
crisis, severe repercussions were felt throughout the financial system as short-term
wholesale lending against all but the very safest collateral froze up. Although short-term
wholesale funding levels at major U.S. and foreign banking firms are lower than they were at
the outset of the crisis, major global banks remain significant users. High levels of such
funding increase the probability of severe funding problems at, and thus the failure of, major
financial firms. They also complicate the orderly resolution of major financial firms in the
event of failure.12 Indeed, precisely because an effective orderly resolution mechanism
provides for continued funding of certain short-term creditors to staunch potentially
calamitous runs, that type of funding will not be subject to the increased market discipline
resulting from the creation of a credible resolution process. This fact only strengthens the
case for measures to limit the potential of short-term wholesale funding to be an accelerant
of systemic problems.
Conclusion
As I stated at the outset, I believe that creation of the orderly liquidation authority in Title II of
Dodd-Frank, the work of the FDIC in developing that authority, the international consensus
on the need for similar authority in relevant jurisdictions, and the continuing dialogue with
academic and policy commentators together constitute a relatively unnoticed success in the
world of financial regulatory reform.
This observation has come with two, probably predictable caveats. First, considerable work
remains, so as to continue building and communicating a credible resolution mechanism that
will allow investors, creditors, and counterparties of large financial firms to form reasonable
expectations as to how a resolution would be conducted. Second, while it is important to
have such a mechanism as part of an overall program to confine too-big-to-fail problems, it
would not be desirable to have to use it. The more desirable outcome would be for its very
credibility to work in concert with capital, liquidity, and other applicable regulations to reduce
the chances of its actual utilization.
These two thoughts bring me to a final point. As I mentioned, serious work is being done by
various commentators on proposals to adapt the Bankruptcy Code to the salient differences
between financial and most other industries. As I have watched the back-and-forth between
those in the official sector charged with developing orderly resolution mechanisms and those
working on bankruptcy amendment proposals, I have noted each side taking account of
some points in favor of the other side's model, with attendant modifications in everyone's
thinking.
Differences remain, to be sure, such as the tradeoff between, on the one hand, a bankruptcy
model's reliance on the independence of the judiciary and the accumulated precedent for
dealing with creditors' claims and, on the other, the advantages in the Title II model of speed,
pre-existing knowledge of financial firms, and a systemic perspective. But there has also
been productive convergence. I join those who believe that the best outcome may be an
amended Bankruptcy Code co-existing with Title II, with the former the default route in the
case of a large financial firm's insolvency, and the latter available for the unusual moment
when systemic risks loom large. The adaptation of the Bankruptcy Code to deal with large,
but not necessarily systemic, financial firms would itself be an important step forward. And
the existence of two options other than bailout or disruptive bankruptcy would be welcome to
anyone who rememb