Daniel K Tarullo: Toward an effective resolution regime for large financial
institutions
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Symposium on Building the Financial System of the 21st Century, Armonk,
New York, 18 March 2010.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Two years ago this week, Bear Stearns succumbed to severe liquidity stress. It was rescued,
and eventually absorbed by JPMorgan Chase, with financing assistance provided by the
Federal Reserve. Although it would take another six months before the accumulating stress
and uncertainty posed an immediate threat to nearly all of our major financial institutions, it is
clear in retrospect that this arranged marriage, and its accompanying dowry of government
financing, set off an expansion of the universe of firms perceived as too big to fail.
During the financial crisis, government authorities in the United States and elsewhere
believed they had only two realistic options in the face of serious distress at a large financial
firm. First, they could try to contain systemic risk by stabilizing the firm through capital
injections, extraordinary liquidity assistance, a subsidized acquisition by a less vulnerable
firm, or some combination of these supports. Second, they could allow the firm to fail and
enter generally applicable bankruptcy processes, risking in those times of fear and
uncertainty a run on similarly situated firms.
The Bear Stearns deal was an example of the first policy option. Lehman Brothers was an
example of the second. When its bankruptcy set off a firestorm in the exceedingly dry tinder
of financial markets in the fall of 2008, the U.S. government decided that further failures of
large, interconnected financial institutions risked bringing down the entire financial system. It
responded to the situation with the Troubled Asset Relief Program to provide capital, and the
Temporary Liquidity Guarantee Program to extend debt guarantees, to large financial firms.
Indeed, faced with the possibility of a cascading financial crisis, most governments around
the world selected the bailout option in most cases. But if the costs of this approach are less
dramatic during a crisis, they are no less significant afterward. Entrenching too-big-to-fail
status obviously risks imposing significant costs on the taxpayer. It undermines market
discipline, competitive equality among financial institutions of different sizes, and normal
regulatory and supervisory expectations.
The desirability of a third alternative to the Hobson's choice of bailout or disorderly
bankruptcy is obvious - hence the prominence during the regulatory reform debate of
proposals for a special resolution process that would allow the government to wind down a
systemically important firm in an orderly way while still imposing losses on shareholders and
creditors. The crisis has also focused attention on the special problems created by the failure
of a large, internationally active financial firm. In my remarks I will elaborate on the
relationship between resolution regimes and an effective overall system of financial
regulation and supervision, both in the international and domestic spheres.1
At the risk of some oversimplification, I would state that relationship as follows: First, an
effective domestic resolution process is a necessary complement to supervision that would
bring more market discipline into the decisionmaking of large financial firms, their
counterparties, and investors. At the same time, even a well-designed resolution mechanism
is no substitute for reformed regulatory rules and strengthened supervisory oversight.
Second, the high legal and political hurdles to harmonized cross-border resolution processes
suggest that, for the foreseeable future, the effectiveness of those processes will largely
depend on supervisory requirements and cooperation undertaken before distress appears on
the horizon. I would further suggest that the importance of proposed requirements that each
large financial firm produce a so-called living will is that this device could better tie the
supervisory and resolution processes together.
A resolution regime for large, interconnected firms
As compelling as the case for such a process is, the debate around resolution proposals has
highlighted the challenge of crafting a workable resolution regime for large, interconnected
firms. The basic design problem is that such a regime must advance the goals of both
financial stability and market discipline. While these goals are usually complementary, they
can at times be competing - especially in periods of high financial stress, when time
consistency problems can loom large. In the midst of a crisis, governments fearful of financial
upheaval can be tempted to provide assistance to supposedly uninsured creditors, even at
the cost of increasing moral hazard in the post-crisis period. Despite the consequent design
difficulties, I think there are certain essential features of any special resolution process.
First, any new regime should be used only in those rare circumstances where a firm's failure
would have serious adverse effects on financial stability. That is, the presumption should be
that generally applicable bankruptcy law applies to nonbank financial firms - even large,
interconnected ones. One way to help ensure that the regime is invoked only when
necessary to protect the public's interest in systemic stability is to use a "multi-key" approach
- that is, one that requires the approval of multiple agencies and a determination by each
that the high standards governing the use of the special regime have been met.
Second, once invoked, the government should have broad authority to wind down the
company in an orderly way. This authority should include - among other things - selling
assets, liabilities, or business units of the firm; transferring the systemically significant or
viable operations of the firm to a new bridge entity that can continue these operations; and
repudiating burdensome contracts of the firm, subject to appropriate conditions and
compensation.
Third, there should be a clear expectation that the shareholders and creditors of the failing
firm will bear losses to the fullest extent consistent with preserving financial stability.
Shareholders of the firm ultimately are responsible for the organization's management (or,
more likely, mismanagement) and are supposed to be in a first-loss position upon failure of
the firm. Shareholders, therefore, should pay the price for the firm's failure and should not
benefit from a government-managed resolution process.
To promote market discipline on the part of the creditors of large, interconnected firms,
unsecured creditors of the firms must also bear losses. Here is where the potential conflict of
policy goals is obvious. While losses imposed on creditors will increase market discipline in
the longer term, the immediate effect could be to provoke a run on other firms with broadly
similar positions or business strategies. Thus the extent of these losses and the manner in
which they are applied may need to depend on the facts of the individual case. At the very
least, however, subordinated debt, or other financial interests that can qualify as regulatory
capital, should be fully exposed to losses.
Fourth, the ultimate cost of any government assistance provided in the course of the
resolution process to prevent severe disruptions to the financial system should be borne by
the firm or the financial services industry, not by taxpayers. The scope of financial institutions
assessed for these purposes should be appropriately broad, reflecting that a wide range of
financial institutions likely would benefit, directly or indirectly, from actions that avoid or
mitigate threats to financial stability. However, because the largest and most interconnected
firms likely would benefit the most, it seems appropriate that these firms should bear a
proportionally larger share of any costs that cannot be recouped from the failing firm itself. To
avoid pro-cyclical effects, such assessments should be collected over time.
Establishing a resolution regime with these characteristics is, I would suggest, one of the
most important financial regulatory reforms for every country that does not already have such
a mechanism in place. It would lend substance to the idea that market discipline can be a
solid third pillar of financial regulation, along with stronger prudential requirements and
improved supervisory oversight. Still, as is implicit in the foregoing discussion, an untested
regime will probably not acquire complete credibility until it is actually applied successfully.
For this reason, among others, it is important to ensure that other regulatory tools will help
compensate for the uncertainties associated with an essentially untested mechanism.
International efforts on resolution issues
The looming or actual failure of a large, internationally active financial firm inevitably
complicates the already challenging process of resolution. Mismatches in the amounts and
maturities of assets and liabilities held by the firm in the various countries in which it operates
can lead host governments to take special action to protect the interests of depositors and
creditors. And different insolvency regimes apply to separately incorporated subsidiaries
across the world. Some of those regimes may be substantively inconsistent with one
another, or may not account for the special characteristics of a large international firm.
A natural response, which one can find peppered through various law journals over the
years, is to propose an international treaty that would establish and harmonize appropriate
insolvency regimes throughout the world. Just to state the proposition is to see the enormous
hurdles to its realization. The task of harmonizing divergent legal regimes, and reconciling
the principles underlying many of these regimes, would be challenge enough. But an
effective international regime would also likely require agreement on how to share the losses
and possible special assistance associated with a global firm's insolvency.
Despite the good and thorough work being undertaken in both the Basel Committee on
Banking Supervision (Basel Committee) and the Financial Stability Board, we must
acknowledge that satisfyingly clean and comprehensive solutions to the international
difficulties occasioned by such insolvencies are not within sight.2 It would certainly be useful
if jurisdictions could at least broadly synchronize both standard bankruptcy and any special
resolution procedures applicable to a failing financial firm. But even this significant advance
would not settle many of the nettlesome problems raised by a cross-border insolvency.
It thus seems reasonably clear that effective management of these problems will, at least for
the foreseeable future, require regulatory coordination and supervisory cooperation before a
large firm's failure becomes a real possibility. In one sense, this observation reinforces the
importance of the international agenda for strengthening capital and liquidity standards. It
also counsels continued attention to efforts to ensure that globally active institutions are
subject to effective consolidated supervision, and that information-sharing arrangements
among home and host country supervisors are well designed and implemented. To this end,
the key supervisors and central banks for each of the largest global banks will begin to meet
regularly to discuss crisis planning, with particular attention to contingency liquidity planning.
The crisis demonstrated that issues around cross-border liquidity support are difficult.
Liquidity pressures may arise in unexpected places, time for coordination will be short, and
failures in one jurisdiction likely will spread quickly to other jurisdictions. The Basel
Committee and the Committee of European Banking Supervisors are each working on
definitions of liquid assets, common stress-testing metrics, and structural balance sheet
measures. We are actively discussing the appropriate division of responsibility between
home and host authorities to provide liquidity support and the related issue of how to
approach cross-border branch operations. Some have called into question the traditional
assumption that home country authorities will be willing and able to support all of the
worldwide operations of a banking group headquartered in its jurisdiction. It is not clear what
approach might work better, but there is an obvious need for broad international consistency
and careful calibration with other prudential requirements.
One of the key issues identified by the Basel Committee's Cross-Border Bank Resolution
Group is the complexity and interconnectedness of the largest organizations. Often the
complexity is motivated by tax or regulatory factors, rather than a clear business purpose.
Given the way these firms are structured and their linkages to key systems and other
institutions, resolution of such an organization will carry significant risk of spillovers to other
key markets, payments systems, or systemically important institutions. The Cross-Border
Bank Resolution Group consequently recommended developing initiatives that would result
in simpler, less interconnected organizational structures.
Living wills
This point leads us to one much-discussed idea, that of firm-specific resolution plans -
sometimes referred to more colorfully, though not wholly accurately, as living wills. This
proposal provides a good opportunity to advance the aim of linking resolution mechanisms to
other regulatory tools, both domestically and internationally.
In one variant of the idea, each internationally active bank would be required to develop, and
potentially to execute, its own resolution plan - literally, to plan for its own demise. Such a
requirement could doubtless be helpful to some degree, but it has notable limitations.
Most obviously, it is very difficult to predict in advance of a crisis which parts of the firm will
be under greatest stress, what geographical regions may be affected most severely, and
what the condition in various markets and economies will be, as well as the stability of
counterparties and similarly situated institutions. Furthermore, governments may be
understandably reluctant to rely too much upon a wind-down plan developed by an
internationally active financial firm that so mismanaged itself that it is on the brink of failure,
placing other institutions at peril. Finally, management of an institution can be expected to
seek to preserve as much value for shareholders as possible in its planning, whereas the
supervisors' objective in a crisis is to achieve an orderly resolution, which will often entail
winding down or restructuring the insolvent firm in ways that effectively wipe out shareholder
interests.
The living will requirement could be broadened so as to make it into a potentially very useful
supervisory tool for healthy firms, as well as a resource in the event that resolution became
necessary. Under this approach, the firm would, in addition to developing a resolution plan,
be required to draw up a contingency plan to rescue itself short of failure, identify obstacles
to an orderly resolution, and show it can quickly produce the information needed for the
supervisor to orchestrate an orderly resolution should the need arise. These plans will need
to evolve as the organization's business and economic conditions evolve, and accordingly,
the plans will need to become a regular part of normal supervisory processes.
A living will of this type could remove some of the uncertainty around a possible resolution. It
would force firms and their supervisors to review contingency plans regularly. As part of their
ongoing oversight, supervisors could target the areas where a firm's planning falls short of
best practices. Focusing on the legal, contractual, and business relationships among the
firm's subsidiaries could yield significant benefits for prudential supervision in normal, as well
as stressed, times. The various elements of the regulatory system could thus be better
integrated by identifying mechanisms and connections for the transmission of risk and liability
between affiliates and by identifying relationships that may present an obstacle to the ready
sales of businesses, the proceeds from which might allow the firm to avoid failure.
Central to the success of a living will as a supervisory tool is the quality of information it
would make available in a crisis. Some of the information would be relatively static. A firm
would have to inventory all of its legal entities, along with the legal regimes applicable to
each one, and map its business lines into legal entities. A firm also would have to document
interaffiliate guarantees, funding, hedging, and provision of information technology and other
key services. This information would be needed to deal with any crisis, no matter what its
specific form.
Once the centrality of accurate, comprehensive information is understood, it becomes
apparent that a very significant upgrade of management information systems (MIS) may be
the only way for the firm to satisfy living will requirements, just as we at the Federal Reserve
found when we led the Supervisory Capital Assessment Program - popularly known as the
bank stress tests - that improved MIS are needed for ongoing risk management at the
institution.
Supervisory demands for improved MIS could have another benefit. Just as a homeowner
has an incentive to shed belongings to reduce the expense of moving, so a financial firm may
have a powerful incentive to simplify its organizational structure and rationalize relationships
among its corporate entities to reduce the cost of developing comprehensive MIS that enable
an organization to retrieve information in multiple formats across jurisdictions, business lines,
and legal entities. Simpler structures can also be encouraged by reemphasizing existing
supervisory guidance requiring banking organizations to measure and manage their risks not
only on the global, consolidated level, but also on a legal entity basis. Together, the
information requirements of living wills and the need to measure and manage risks at the
legal entity level can help create the right incentives for firms to simplify their structures
without necessarily requiring a supervisor to delve into the details of a banking group's
structure.
Conclusion
All of this work on
resolution, both domestic and international, is important and necessary.
But we must be realistic about what it can accomplish. In light of what has happened over the
past two years, it is imperative that governments convince markets that they can and will put
large financial firms into a resolution process rather than bail out creditors and shareholders.
Yet no one can guarantee that future resolutions of systemically important firms will proceed
smoothly or predictably. Resolution mechanisms must be understood not as silver bullets,
but as critical pieces of a broader agenda directed at systemic risk and the too-big-to-fail
problem.