Standard & Poor’s Ratings Services believes that the primary goal of DFA is to make banks less risky and better capitalized so the need for extraordinary support is reduced. However, given the importance of confidence sensitivity in the effective functioning of banks, we believe that under certain circumstances and with selected systemically important financial institutions (SIFI), future extraordinary government support is still possible.
The U.S. government has a long track record of supporting the banking system. But the government’s authority to regulate and supervise hasn’t always prevented bank failures or the need for selected bailouts or tailored assistance. Time and time again, the U.S. government has found ways--many times reluctantly--to contain systemic risk and limit economic fallout when large financial institutions are on the brink of failure. The government has done this through outright new capital instruments (i.e., net-worth certificates), open-bank assistance, and simple regulatory capital forbearance.
Whether the U.S. government will remain “supportive” of its banking industry has come into question as a result of constraints that Title II (Orderly Liquidation Authority or OLA) of DFA imposes. “Supportive” here focuses on extraordinary government support, not just ongoing system support. DFA attempts to create a comprehensive and robust regulatory framework and, in our opinion, effective implementation may provide a good theoretical blueprint to promote financial stability and reduce systemic risk. However, this legislation, in our view, has not addressed the demand side of risk, risk mitigation efforts, or the fact that a two-tier regulatory system will likely continue to move risks into the loosely regulated shadow banking system.
Title II may not be enough either to prevent systemic failures or to address the orderly resolution of a SIFI as legislators and regulators have hoped. The fragility of market confidence came to the fore in the most recent crisis. We believe regulators can create prudential standards to promote market stability. But it is difficult to create legislation that ensures market confidence at all times despite a regulator’s attempt to promote it, such as through the increase in deposit insurance coverage to $250,000. We believe that implementation of OLA could increase uncertainty in the market at a time when confidence needs boosting. For instance, dismantling a large financial firm might spur creditors to pull out of other similar financial firms in times of stress. Creditors may react by cutting off funding sooner and accelerating the failure process. One lesson from the recent crisis is that fund providers’ loss of confidence can very quickly trigger liquidity events, which can lead to a firm’s failure. So although DFA constrains the type and form of support that the government can give (i.e., the financial firm has to be in liquidation), we believe that amendments to the current legislation or outright changes in a future crisis might prove necessary, especially when the government faces circumstances that could depress the real economy and threaten the well-being of its citizens.
Legislation And Financial Crises—Moving To OLA
In response to outsize financial crises that have involved numerous or large banks, legislators and regulators usually have responded with changes--some significant--to banking legislation and regulation. They cite the need to avoid a repeat of past mistakes and ensure that financial institutions are strong enough to weather the next crisis. To be sure, the regulatory reform of the 1930s worked relatively well for 50 years, with only 584 bank failures--about 3%-4% of the total average number of commercial banks during that entire period. The situation changed sharply in the 1980s, and legislators and bank regulators deregulated interest rates to increase the effectiveness of monetary policy in a high-inflation environment. The Monetary Control Act of 1980 and Garn-St. Germain in 1982 were the centerpieces of this deregulation. The freeing of bank interest rates, however, led to large losses in the financial sector. For instance, there were more than 1,800 failures and Federal Deposit Insurance Corp. (FDIC)-assisted transactions (or an average 13% of all FDIC-insured institutions) from 1983 to 1989. In fact, the FDIC has argued that those acts increased the direct cost of resolving the savings-and-loan crisis, which the Government Accountability Office estimates at about $160 billion, or roughly 2% of gross domestic production in 1995 when Congress terminated the Resolution Trust Corp. Likewise, FIRREA in 1989 and FDICIA in 1991 failed to prevent the savings-and-loan or banking crises, and were more reactive in nature. More recently, the FDIC has reported about 370 failures and assisted transactions since 2008, or about 4% of the total number of banks and thrifts. The loss to the deposit insurance fund was $57 billion in 2009 alone, according to the FDIC, but this does not reflect the full cost of the support provided.
A sharp economic downturn accompanied by extremely high losses and a loss of confidence in the banking sector can amplify a downturn. Because currency and demand-deposit liabilities of banks constitute the means of payment in the economy, governments have been particularly interested in maintaining depositors’ belief that they can withdraw their money at par at any time. As deposit-taking financial institutions and their bank holding companies have become more complex or diverse, and as they have had to compete with other sectors of the financial industry, they have had to rely more on market funding. This funding can flee or stop if confidence in repayment erodes, unless the market believes the bank is too big to fail (e.g., its size will impel governmental authorities to keep it functioning through extraordinary funding or guarantees).
Much is at stake when large and strongly interconnected financial institutions fail in a disorderly fashion. Title II of DFA provides a blueprint for the orderly resolution of large and systemically important bank holding companies and nonbanks (as “covered companies”) by the FDIC and establishes the Financial Stability Oversight Council (FSOC) to identify these covered companies. In particular, Title II provides the framework for what banking regulators can or cannot do for the orderly resolution of failing SIFIs in liquidation. In theory, an orderly liquidation would limit the contagion inherent in a large, globally interconnected financial institution’s failure. The U.S., however, is not alone in seeking to limit government support for banks. Globally, much attention has focused on the adoption of regulatory frameworks and resolution regimes that eliminate or at least sharply reduce the moral hazard of too big to fail.
The FDIC already has broad powers to resolve an insured depository institution in a manner that minimizes disruption to the banking system and maximizes value. In addition, DFA through OLA allows the FDIC to create one or more bridge banks, enforce cross-guarantees among sister banks, sell and liquidate assets, and settle claims. The OLA can apply to bank holding companies, broker/dealers, insurance companies, or any other financial company under the supervision of the Federal Reserve if the Secretary of the Treasury, the Fed, and other firm-specific regulators vote to agree. Those voting must consider, among other things:
- Whether the company is in default or near default;
- The effect that default might have on financial stability in the U.S.;
- If there is a private-sector alternative to default;
- Why the bankruptcy code might not be appropriate; and
- What effect default would have on shareholders, creditors, counterparties, etc.
The Secretary of the Treasury then takes action if, among other considerations:
- The failure of the company and its resolution under otherwise applicable laws would hurt financial stability in the U.S.;
- No viable private-sector alternative exists;
- The impact on shareholders, creditors, and counterparties is appropriate given that action; and
- Federal regulators have already ordered the conversion of all convertible debt instruments.
The key to the FDIC’s authority as receiver of a covered financial company is its ability to:
- Conduct advance resolution planning for SIFIs;
- Provide immediate liquidity for an orderly liquidation;
- Make advances and prompt distributions to creditors based upon expected recoveries;
- Create bridge financial companies to continue systemically important operations; and
- Transfer all qualified financial contracts with a given counterparty to another entity and avoid their immediate termination and liquidation.
In an orderly liquidation, Title II mandates that creditors and shareholders share in losses if claims exceed the value of assets, that top management and other responsible parties not be retained, and that creditors bear losses including financial damages and recoupment of compensation. To those ends, DFA specifies that the FDIC should ensure that shareholders do not receive payment until the bank pays all other claims, and that unsecured creditors bear losses in accordance with the priority of claims provisions. The FDIC is also prohibited from taking an equity interest in any covered financial company or subsidiary.
Banks May Need Extraordinary Government Support After All
Bank regulators are working toward meeting DFA’s rule-making deadlines. But some general implementation details are still unclear or undetermined. Notwithstanding, we believe that the OLA powers that DFA gives to regulators will not by themselves prevent future government support of a handful of individual financial institutions. From our perspective there are several reasons why regulators will likely face obstacles in executing an orderly resolution of failing banks and ensuring that confidence in financial markets does not erode during periods of stress.
Franchise stability and market confidence are critical
Our fundamental criteria on assessment of liquidity focus on the stability of funding sources, where core retail deposits are preferable to wholesale sources of funds, particularly if they are short term. Although most financial institutions are vulnerable to a loss of confidence (because they typically fund most of their assets with debt), some wholesale banks and nonbank financial companies are more vulnerable than others depending on their business models and funding mix. For instance, specialist lenders that depend on short-term wholesale funding and financial institutions with large trading operations are particularly sensitive to an erosion of confidence. For all banking institutions, the worst-case result of an erosion of confidence is a significant outflow of wholesale or retail customer deposits (a bank run).
We believe that financial institutions most exposed to volatile markets and loss of investor and counterparty confidence will likely continue to be vulnerable to loss of market access. Consequently, 'sudden default' risk will likely remain a characteristic of large and complex financial institutions, although the significant measures that governments around the world have taken to shore up funding and liquidity requirements should reduce this risk somewhat.
Large financial firms are structurally complex
Many large institutions are functionally organized around lines of business to improve efficiency, to manage risk effectively, to support product capabilities, to provide access for customers, to minimize tax liabilities, and to hedge against regulation, among other reasons. The functional structure, however, will not necessarily match the legal structure. As a result, a given function or business may operate in many separately incorporated lines of business from a multitude of jurisdictions. The resulting structural complexity can make resolution planning and execution more difficult.
Cross-border operations will be subject to different jurisdictional regimes and timelines
DFA does not consider wind-down situations following a group methodology--that is, dealing with foreign subsidiaries of U.S. financial institutions or troubled subsidiaries of foreign firms operating in the U.S. Legislators assumed that foreign regulators would cooperate with U.S. banking regulators in such matters. In addition, as institutions identify gaps and impediments, some remediation efforts may take longer to plan and implement. International regulators may not act in coordination with the FDIC, making deployment of an effective global resolution plan difficult.
Effective execution of living wills and long-term resolution planning
DFA requires that covered financial institutions submit a resolution plan for their orderly liquidation by the FDIC if they become insolvent (a “living will”). However, we believe that these plans ought to be integrated with long-term strategic planning into the larger risk framework of the organization because the information requirements are different from those needed on a day-to-day basis. Moreover, plans need to be flexible because the actual insolvency situation may be very different from the planned-for scenario. Moreover, creating a living will that will be useful in an unforeseeable crisis is inherently difficult. Lastly, putting reasonable and workable living wills in place may take years. From our perspective, the most-recent financial crisis is not completely over. Therefore a SIFI without a workable living will could get in trouble in the near term.
Management issues
It will be important to identify the appropriate people to advance the enterprise and execute the wind-down process. Covered companies by definition will be large and complex--quite different from the type of banks the FDIC has a history of receiving and resolving. Retaining critical managers and motivating them to work in the wind-down of business may be key to the overall success of the orderly resolution.
Enhanced macroprudential capital standards may not be enough to contain the loss of confidence
Bank regulators intend to increase minimum regulatory capital standards and include an extra buffer for systemically important financial firms. Details and specifics are still under discussion, although the Basel committee has announced a 1.0%-2.5% capital buffer for SIFIs. However, it could apply an incremental 1% add-on for firms at the top end of the range to discourage the largest banks from becoming significantly bigger. Undoubtedly, more capital (especially common equity) is better than less. But the banks that failed, were provided extraordinary assistance, or were acquired just before failure presented high regulatory capital ratios. Thus, high regulatory capital ratios in and of themselves may not be enough to preempt a “run on the bank” as regulators expect, which reveals some limitations of a rule-based system. The market may start recognizing lifetime losses of risky assets all at once, as happened in the fall of 2008. Because unrealized losses that made banks appear stronger than they otherwise would have were not considered in regulatory tier 1 capital during the crisis, the market put more value in tangible common equity ratios.
The FDIC attempted to address questions about how it would have resolved the Lehman Brothers failure under OLA. We agree the transfer of qualified financial contracts (including swaps, repos, securities contracts, commodity contracts, and similar agreements) to a bridge or acquiring company under OLA should help mitigate the market-wide disruption a large-scale bankruptcy might cause. But some issues remain unresolved: Would the FSOC have identified Lehman as a SIFI? Would there have been enough financial information about emerging risks to classify it accurately as such and resolve it? Would its “living will” have been reasonable for a wind-down? Would the FSOC have assessed the potential global impact properly? Would bank regulators abroad have cooperated with the FDIC in its resolution? New products and markets develop rapidly, and the risks inherent in those new products often become apparent only through a crisis. Faith in the OLA relies on the belief that risks can be identified early and mitigation can be planned.
The Three Categories Of Government Support
Extraordinary support became most evident in the U.S. on Oct. 14, 2008, when the government, through a joint statement by the Federal Reserve Board, the Treasury, and the FDIC, announced three actions following the enactment of the Emergency Economic Stabilization Act of 2008. These included a voluntary capital purchase program (CPP) whereby U.S. financial institutions would sell preferred shares to the government; the Temporary Liquidity Guarantee Program, which allowed the FDIC temporarily to guarantee the senior debt of all FDIC-insured institutions and certain holding companies; and the Fed’s Commercial Paper Funding Facility program to fund purchases of high-quality issuers’ three-month commercial paper. Initially, nine financial institutions signed up for the CPP and to have the FDIC guarantee their debt. At that time, authorities also identified these nine institutions as systemically important, implying that the breadth and scope of their operations and exposures were such that non-support would likely destabilize the global financial system. In our view, these actions helped stabilize the financial system and restore market confidence.
We currently classify governments into three categories: interventionist, supportive, and support uncertain.
Interventionist
Interventionist governments tend to make support for systemically important banks explicit on an ongoing basis, demonstrate this frequently through government actions, and are likely to continue such policies. Tangible forms of support can include subsidies, financial injections, and ownership links. Examples include Japanese authorities' support of systemically important banks through the stresses that began in the 1990s.
Supportive
Supportive governments rely on prudential policies--including mechanisms to support failing banks--to maintain a sound banking sector. They are likely to provide more-explicit individual targeted support systemically important banks in a crisis. The nature of this support is likely to depend on the health of the bank, and would become more explicit and targeted in response to a particular problem at a bank.
When banks are performing well in such countries, the authorities rarely have a need or incentive to provide direct financial support. The governments in these countries, however, promote the soundness of their banking systems through prudential standards, reinforcement of the legal infrastructure, and robust liquidity mechanisms.
Some banks will receive significant direct support from the authorities in the event of a problem, but the authorities may decide not to provide direct support to another bank, instead coordinating the provision of support by other market participants (such as the purchase by another entity). Other banks may be allowed to fail or to proceed to a relatively orderly wind-up, particularly if a market-based solution is not successful.
Such governments are likely to base the decision to support a bank on a cost-benefit consideration of the economic and social implications of the bank's failure versus the cost to the taxpayers of a bailout. In some circumstances, the authorities may face financial or legal constraints affecting the type of support that they can provide. The nature and timing of the support a supportive country would provide may differ depending on the profile of the bank and the cause of the bank's problem. Various classes of creditors may receive different levels of support. Because many of these countries are increasingly oriented toward market-based solutions, the government or regulators may guide or direct other banks toward a takeover of the troubled bank. In other situations, the support could come in direct financial form, or through some type of regulatory forbearance.
Support uncertain
A support uncertain government may support banks, but its policy is unpredictable, either because of a weak institutional infrastructure or reliance on market solutions or bank owners. Governments in this category may intervene when major private-sector banks are failing, but they are more likely to let events run their course, allow a private-sector solution, or let bank owners support failing banks. Countries in this category may have undeveloped or unpredictable bank regulation and relatively weak political institutions.
The more a country's bank regulation advances toward best practices, the more likely it will be in the 'supportive' rather than 'support uncertain' category, even if its economic policies are market oriented. In countries classified as 'support uncertain,' it is very difficult to predict the responses of the national authorities to a stress at a systemically important bank. We do not incorporate the potential for external support into our bank ratings until we are certain of the government response. When there is sufficient clarity about the government actions, then the ratings will incorporate the benefits.
We may not consider governmental support in rating junior securities to the same extent as we consider it in counterparty and senior debt ratings, if at all. Ratings on instruments like preferred stock and hybrid equity on which payment may be deferred, for example, may be substantially lower than the issuer or senior debt ratings if we feel government support would not prevent payment default on the junior instruments.
Why We May Rethink Our View Of Extraordinary Government Support
We classify the U.S. as supportive, because despite its general belief in the market's dominant role in economic policy, it maintains extensive regulation that empowers banking regulators and emphasizes proactive measures to identify and cure problems at the onset. Under our proposed new bank criteria, among the characteristics that we would look for to change the classification to support uncertain are an unambiguous policy or legislation preventing direct support to financial institutions under any condition or an explicitly mandated loss-sharing of senior unsecured creditors on losses related to a bank failure.
Under current criteria, our approach to reflect potential extraordinary future external support in bank credit ratings treats the interventionist category differently from the supportive and support uncertain categories. The credit ratings on systemically important private-sector banks in interventionist countries receive an explicit uplift over the stand-alone ratings (which exclude extraordinary external support). This uplift typically is one notch, although it can reach three notches or more in cases of troubled private-sector banks. Under our proposed new bank criteria, we propose recognizing government support throughout the cycle and not just during a crisis when we consider government support to be sufficiently high. The extraordinary government support we expect a bank to receive is by no means certain. This uncertainty means that the support uplift will never result in equal ratings on a nongovernment-related bank and the sovereign.
Under both existing and proposed criteria, we regard the likelihood of government support for private-sector commercial banks as a function of both the bank's importance in maintaining overall confidence in the financial system (or what we call systemic importance) and the government's tendency to support private-sector commercial banks. We regard private-sector commercial banks as having high, moderate, or low systemic importance. We then combine these two factors to derive the likelihood of direct government support in the future for private-sector commercial banks.
We rate banks with a direct link to government ownership or policy banks that may have a claim to the government under our government-related entities (GRE) criteria. We apply a closely related methodology in rating banks that the government directly owns or controls, and policy institutions such as export credit banks. We treat state banks, policy financial institutions, and state enterprises in other economic sectors as GREs, reflecting their closeness to the government and the strong likelihood that the government will take direct actions that will affect their creditworthiness. We also categorize systemically important private-sector banks in interventionist countries as GREs.
A “Wait-And-See” Mindset
In the words of Fed Chairman Ben Bernanke during his testimony before the Financial Crisis Inquiry Commission on Sept. 2, 2010, 'A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.'
We expect the pattern of banking-sector boom and bust and government support to repeat itself in some fashion, regardless of governments' recent and emerging policy response. Governments support their national economies and financial systems and this support often results in added protection for senior creditors of systemically important commercial banks, but the link is by no means certain. Confidence is important in banking because institutions borrow short and lend long. Their risk appetite and shareholder-return goals compound the issue.
The U.S. government indeed has a long track record of supporting its large and systemically important financial institutions despite its stated preference for not doing so. DFA may limit this activity, but we believe the government may try to avoid contagion and a domino effect if a SIFI finds itself in a financially weakened position in a future crisis. The rules and regulations resulting from DFA and Title II could be amended or changed. After all, with a loss in confidence similar to the situation in 2008, the government will be motivated to ward off the market’s question: “Who is next?” Ultimately, in our views of new legislation and regulation, we need to consider the long track-record of extraordinary support that may be essential for a handful of institutions despite government reluctance to offer such support.
The U.S. banking system is more concentrated today than it was before the crisis. To illustrate, the top five commercial banks now hold half the banking system’s assets, compared with 45% at the end of 2005. Banks with more than $50 billion in assets comprise 75% of the system’s assets, and thus we think it would be impractical to consider all of them SIFIs given this low threshold. Higher deposit-insurance coverage may translate to greater sovereign exposure, even as systemic risk may be reduced by providing a higher comfort level to depositors. Moreover, a two-tier regulatory system likely will continue, shifting emerging risks to the loosely regulated shadow-banking system as in the past. With lower returns expected from a more highly capitalized banking system, the search for risk will likely shift toward the shadow-banking system.
Lastly, in an effort to reduce banks’ risk, exchanges and clearinghouses will assume more risk under DFA. In the end, banking regulators will have fewer tools to deal effectively with troubled financial institutions.
There has been much discussion about the true implications of DFA and whether it has, in fact, eliminated “too big to fail.” The market perception indicates the whole spectrum of outcomes, from complete certainty of bond default for a SIFI to a “maybe under certain conditions” outcome, in which senior bondholders may not bear any losses. Finalization of certain rules and regulations and future amendments to DFA could alter our view of whether the U.S. remains “supportive.” But, for now, we agree with Alan Greenspan’s statement before the Council on Foreign Relations in New York City on Oct. 15, 2009: “If they’re too big to fail, they’re too big.”"
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