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TBTF and The Single Point of Entry (SPOE): Part Two

posted by Jay Lawrence Westbrook

In an earlier post I described the FDIC’s proposed SPOE approach to resolution of SIFI banks and other financial institutions under Title II of Dodd-Frank. That post discussed two of the three components of SPOE: control of the process by the regulator and no bailout for management or owners. This post lays out the role of the third component, the “forlorn hope” debt. Shutterstock_95970961

That debt is unsecured debt owed to a bank holding company (BHC) and predestined to get little or nothing in case of the failure of the BHC. It serves in effect as a debt reserve to buffer the financial distress of the bank group. By being dumped, it would make the group as a whole solvent. By contrast, legislation already passed by the House would ignore the need for the reserve, thus setting up another bank bailout. The reserve debt component of SPOE awaits a strong rule from the Fed to make it a reality. This post discusses what the rule must do.

The debt reserve is assumed to be a large amount of unsecured debt the BHC issued in happier times. Under Title II, the FDIC would put a failing BHC into a receivership and spin off all the subsidiaries, including the actual bank, into a newly created BHC, BridgeCo, which is intended to be made solvent by virtue of its separation from the reserve debt of the original BHC. The holders of reserve debt would likely receive little or nothing and would be warned of that when they bought their bonds.

The idea is that this debt-reserve approach (in Europe often called “bail-in”) avoids or reduces the need for public money for the rescue of BridgeCo. The FDIC proposal concedes that some public money may be required. Most of us who have looked at it are quite sure at least temporary public money and the backing of the United States government will be necessary. Nonetheless, dumping the reserve debt as a quick path to solvency is a useful idea.

There has been little public discussion of the fact that the left-behind debt amounts to a reserve. Its benefit is much the same as the capital or asset reserve required by Basel III, but in reverse: instead of a buffer of assets it provides a buffer of disposable debt. No such debt reserve is now required of SIFIs, but the Fed is supposed to issue a rule that will impose that requirement.

The content of the Fed rule is crucial, because this reserve, just like a capital reserve, is subject to estimation and manipulation and therefore to regulatory capture or fatigue. Just as a regulator must decide how large a capital reserve has to be to be adequate, the Fed will have to set a formula to determine how much of this debt reserve each BHC needs to sell to risk-loving bondholders to serve the buffer function for the SPOE process.

Second, just like a capital reserve, the required debt has to be of a type to meet the purpose. We all remember the “risk-free” mortgage bond tranches, along with Greek sovereign debt, that were once claimed as rock-solid elements of the capital reserve (asset) requirements. Similarly with the debt reserve, the Fed rule needs to protect against exotic instruments and workarounds that will look like long-term unsecured debt but somehow tie back to collateral or to value in the subsidiaries in God knows what complex ways the “rocket scientists” will invent, thus defeating its purpose.

Management will be eager to avoid issuing the right kind of reserve debt, because bondholders who are told in advance they will be dumped overboard when the storm comes will demand a hefty return. Management will thus encourage the guys in the basement to invent debt that looks disposable but doesn’t really disappear. For the sake of the global financial system, the Fed rule had best be airtight and the regulators keen to enforce it. 

Graph image from Shutterstock

Comments

Great stuff, Jay. I hope you are working on a longer piece on these issues! I want to hear more.

Why is the buffer in the form of unsecured debt, as opposed to a simple equity mandate?

A-
There are several answers to your excellent question:
1. Debt is an objective number. Equity is whatever an accountant says it is.
2. Zero (or very low) equity is a trigger. If you have low equity and high debt, the trigger is much easier to pull, and things will be less disastrous when you pull it.
3. (Only for true believers) High debt motivates managers.

Didn't HR5421 provide for an immediate sale of holding company assets (including equity in bank subsidiaries) to a non-debtor bridge company for resolution outside of bankruptcy? The chapter 11 case would still be there, but the only asset in the estate would be bridge company equity. The unsecured debt buffer would be "left behind" to perhaps collect something from ownership of the bridge company. How does this differ from Title II, other than the lack of direct governmental control of the process?

The lack of government control is the central defect of HR5421. That control is central to preservation of the public interest in the crisis of a SIFI collapse and without that control (and backing) the market will not stabilize. On top of that foreign regulators will not accept private control. The post also points out there will be no "left behind" (and likely "forlorn") debt without a Fed Rule requiring it and specifying its amount and terms.

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