Chairman McHenry, Ranking Member Green, and members of the Subcommittee, thank you for the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC) on Sections 165 and 121 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Our testimony will focus on the FDIC’s role and progress in implementing Section 165, including the resolution plan requirements and the requirements for stress testing by certain financial institutions.

Section 165 of the Dodd-Frank Act

Resolution Plans

Under the Dodd-Frank Act, bankruptcy is the preferred resolution framework in the event of a systemic financial company’s failure. To make this prospect achievable, Title I of the Dodd-Frank Act requires that all large, systemic financial companies prepare resolution plans, or “living wills”, to demonstrate how the company would be resolved in a rapid and orderly manner under the Bankruptcy Code in the event of the company’s material financial distress or failure. This requirement enables both the firm and the firm’s regulators to understand and address the parts of the business that could create systemic consequences in a bankruptcy.

The FDIC intends to make the living will process under Title I of the Dodd-Frank Act both timely and meaningful. The living will process is a necessary and significant tool in ensuring that large financial institutions can be resolved through the bankruptcy system.

…continue reading: Examining the Application of Title I of the Dodd-Frank Act

On April 15, 2013, the Board of Governors of the Federal Reserve System (Federal Reserve) and the Federal Deposit Insurance Corporation (FDIC) issued additional guidance (Guidance) with respect to the 2013 resolution plan submissions of the U.S. and foreign banking organizations that filed their initial resolution plans on July 1, 2012 (First-Round Filers).

The Guidance shows that the Federal Reserve and FDIC are intensifying their credibility review of resolution plans, requiring analysis of the most challenging issues raised by a Covered Company’s failure. Responding to the Guidance will require First-Round Filers to address head-on difficult questions raised by their original submissions. In recognition of the amount of new information required to be supplied, the Guidance extends the 2013 submission date for First-Round Filers to October 1, 2013.

Although by its terms the Guidance is limited to the plans of the First-Round Filers, it suggests that banking organizations in the second and third filing rounds may be required to undertake more searching analysis in their submissions next year.

In this post, we discuss the most significant aspects of the Guidance:

…continue reading: Guidance on Resolution Plans of U.S. and Foreign Banking Organizations

As many of you know, I am now in my second term as an SEC Commissioner and this is my fifth time participating at SEC Speaks. During that time, I have served with three different SEC Chairmen, and a fourth is now in the works. It has been, and continues to be, a great privilege to serve at a time during which the SEC’s role as the capital markets regulator has never been more important. However, I must admit being frustrated that we haven’t done more to protect investors.

Clearly, my tenure as a Commissioner has been dramatically impacted by the financial crisis and the pressing need to address the many failings that were brought to light by that crisis. Throughout my tenure, I have worked to be a strong advocate for fulfilling the Commission’s mission to protect investors, facilitate capital formation, and promote a fair and orderly market. To that end, I want to talk to you today about the need to protect investors through robust and effective market oversight.

I am growing increasingly concerned about the stability of our market structure as we lurch from one crisis to another, be it the flash crash or the Knight trading fiasco. Today, I plan to focus on the dangers that investors face from a trading market structure that has shown too many signs of weakness and instability.

…continue reading: Addressing Market Instability through Informed and Smart Regulation

Summary

On December 17, 2012, the staff of the Federal Reserve issued a Supervision and Regulation (“SR”) letter describing the Federal Reserve’s new framework for consolidated supervision of large financial institutions. SR letters address significant policy and procedural matters related to the Federal Reserve’s supervisory responsibilities.

Under the new framework, the Federal Reserve’s primary supervisory objectives for large financial institutions will be (1) to enhance resiliency of an institution to lower the probability of its failure or its becoming unable to serve as a financial intermediary, and (2) to reduce the impact on the financial system and the broader economy of an institution’s failure or material weakness. These objectives are meant to conform to key provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, such as enhanced prudential standards for large financial institutions. Although the Federal Reserve has not previously stated these objectives as its primary supervisory objectives, and the new framework formally integrates areas such as corporate governance and compensation that Federal Reserve staff has been focused on since the financial crisis, changes in specific supervisory expectations are limited. Changes include greater emphasis on recovery planning in the case of financial or operational weakness, and on orderly resolution planning, as required by the Dodd-Frank Act. The Federal Reserve will also engage in greater “macroprudential” supervision to detect systemic risks.

The new framework applies to the largest and most complex financial institutions subject to consolidated Federal Reserve supervision, including nonbank financial companies designated by the Financial Stability Oversight Council for supervision by the Federal Reserve; other domestic bank and savings and loan holding companies with consolidated assets of $50 billion or more; and other foreign banking organizations with combined assets of U.S. operations of $50 billion or more.

…continue reading: Federal Reserve Updates Consolidated Supervision Framework for Large Financial Institutions

On December 10, 2012, the Federal Deposit Insurance Corporation (“FDIC”) and the Bank of England released a white paper, Resolving Globally Active, Systemically Important, Financial Institutions, [1] describing how each would resolve a materially distressed or failing financial institution that is globally active and systemically important (“G-SIFI”) in order to maintain the G-SIFI’s ongoing and viable operations, and contain any threats to financial stability. The paper reflects the work of U.S. and UK authorities [2] in developing resolution strategies for the failure of G-SIFIs in accordance with standards developed by the Financial Stability Board, [3] but does not go into detail on the strategic options that may be available.

The white paper warrants the close attention of G-SIFIs and their stakeholders, particularly their unsecured debtholders. The paper memorializes the consensus view of the FDIC and the Bank of England that a top-down or single-point-of-entry approach is the preferred (although not the sole) method of resolving a G-SIFI. [4] This approach could transform certain unsecured debt into equity or convertible debt and should cause G-SIFIs to review their organizational structure. Also of interest are the FDIC’s and Bank of England’s perspectives on the critical powers and preconditions for a successful resolution and what legislative or regulatory changes may be necessary.

…continue reading: FDIC and Bank of England Release White Paper

It is hard to imagine a financial crisis that is not ultimately caused by creditors who had taken on too much debt. Debt is the root cause of most corporate financial failures and, if a snowball effect sets in, the root cause of financial system failure. Of course, debt also has advantages. Without debt, many privately and socially valuable projects could never be undertaken. Still, it is our current tax system that has pushed our economy to be too levered. Now is the time to address the problem—before it will again be too late.

From a creditor’s perspective, the two key advantages of debt are the tax deductibility of interest payments and the ability of lenders to foreclose on non-performing borrowers (which makes it in their interest to extend credit to begin with). Although both factors contribute greatly to the incentives of the borrower to take on debt, there is one important difference between them: the tax deductibility of debt is not socially valuable.

To explain this issue, let’s abstract away from the beneficial real effects of debt and consider only the tax component. In an ideal world, taxes should not change the decisions of borrowers and lenders. They would take exactly the same projects and the same financing that they would take on in the absence of taxes. At first glance, one might argue that the tax distortions of leverage are not so bad, because the interest deductibility of the borrower is offset by the interest taxation of the lender. But this “wash argument” is wrong. It ignores the fact that capitalist markets are really good at allocating goods to their best use. In this case, it means that the economy will develop in ways that many lenders end up being in low tax brackets (such as pension funds or foreign holders) ,while many borrowers end up being in high tax brackets (such as high-income households or corporations). The end result will be not only that the aggregate tax income is negative, but that debt is taken on by borrowed primarily to reduce income taxes and not because debt has a socially productive value.

…continue reading: A Simple Tax Proposal to Improve Financial Stability

In the post-financial crisis regulatory reforms, emphasis has been placed on creating recovery and resolution frameworks for banks, which ensure that the costs of failure are born by private parties (primarily shareholders), instead of taxpayers and the wider economy. Supervisors have (or will have) extensive powers on banks, e.g. to remove and replace directors, to appoint “special managers”, to transfer shares and assets of banks to third parties, and even to cancel existing shares and issue new shares in order to “replace” existing shareholders. The purpose of this article, Bank Recovery and Resolution: What About Shareholder Rights?, is to examine the potential impact of bank recovery and [1] and of the United Kingdom (the special resolution regime for banks established by the Banking Act of 2009).

The article begins by studying the rationale for shareholder protection, especially in the banking sector. It subsequently studies the main shareholder rights, which include: property rights, governance rights (including pre-emption rights, appointment of directors and involvement in management), procedural rights, protection of minority shareholders, and protection of shareholders in banking groups (through the principles of separate legal personality and limited liability).

…continue reading: Bank Recovery and Resolution: What About Shareholder Rights?

The first wave filers – the largest and most complex domestic and foreign bank holding companies – have now filed their living wills and the public portions have been posted on the FDIC’s and the Federal Reserve’s websites. Based on our experience advising a number of banking institutions on their resolution plans, and based on the public portions of the plans, we believe there are lessons to be learned for second and third wave filers, even in this early stage of an iterative process. At the same time, these lessons should be drawn carefully in light of the fact that the business models and legal structures of the second wave filers are somewhat different from the first wave filers, and those of the third wave filers are very different. Any lessons learned from the first wave should also be tempered by the fact that the standard format for the living wills that the regulators required in the first wave is likely to change for second and third wave filers. With that in mind, we suggest the following key lessons from the first wave filers based on what is known immediately after their public filings.

…continue reading: Living Wills: Key Lessons from the First Wave

On June 19, 2012, the Financial Stability Board (FSB) issued a progress report to the G20 Leaders on the steps FSB member nations have taken to implement financial reforms designed to improve the stability of the global financial system. The FSB reviewed, among other things, its members’ Basel implementation, adoption of resolution-planning regimes, oversight of the so-called “shadow banking system,” reform of the OTC derivatives market, and the effectiveness of the FSB itself. The FSB concluded that its member nations have made significant progress in implementing globally agreed financial reforms, but large strides are still necessary – particularly regarding recovery and resolution planning – to protect the global economy against future financial crises.

What is the FSB?

The FSB is an informal body of financial regulatory authorities from the G20 nations and the former members of the Financial Stability Forum. It was established in 2009 – in the wake of the 2008 financial crisis – with the intent of improving global financial stability by coordinating the way in which the world’s major economies implement their own financial reforms. At present, the FSB is not an independent legal entity but acts under the auspices of the Bank for International Settlements (BIS), an international organization that assists central banks in promoting financial stability and serves as an international central bank itself. The FSB has no enforcement authority; it derives its legitimacy from the cooperative participation of its member nations. As described below, however, the FSB’s institutional power may be growing: the G20 Leaders recently granted the FSB authority to organize itself as an independent legal entity.

…continue reading: FSB Reports Regulatory Reform Is Advancing, But Slowly

I would like to take the opportunity to discuss one of those challenging issues – the orderly resolution of systemically important financial institutions ( SIFIs). The Dodd-Frank Act provided important new authorities to the FDIC to resolve SIFIs. Prior to the recent crisis, the FDIC’s receivership authorities were limited to federally insured banks and thrift institutions. There was no authority to place the holding company or affiliates of an insured institution or any other non-bank financial company into an FDIC receivership to avoid systemic consequences. The lack of this authority severely constrained the ability of the government to resolve a SIFI.

This authority has now been provided to the FDIC under the Dodd-Frank Act. The question is whether the FDIC can develop the operational capability to utilize this authority effectively and a credible strategy under which an orderly resolution of a SIFI can be carried out without putting the financial system itself at risk. These key challenges have been the focus of the FDIC’s efforts since the enactment of the Dodd-Frank Act in July 2010. I would like to focus my comments today on the progress we have made in meeting these important challenges.

…continue reading: FDIC’s Orderly Liquidation Authority