FDIC and Financial Firm Breakups

A few weeks ago U.S. regulators approved an initial rule for the government to seize and dismantle large, troubled financial firms, including a stipulation that, in limited cases, could allow other creditors to get more favorable treatment. The Federal Deposit Insurance Corporation (FDIC), an institution created in the 1933 Great Depression to restore public confidence in the nation's banking system, proposed a system under the Dodd-Frank Act passed in July which aims to reform financial regulations in the economic crisis and prevent eventual risks. The rule specifically examines the treatment of creditors when a big bank is dissolved using the system.

The FDIC's proposal, which will be open for 30 days of public comment once it is formally published in the Federal Register, would wind down a bank or other financial company considered "too big to fail", whose bankruptcy or other insolvency procedures would pose a significant risk to the entire economy. According to this financial rule, shareholders, subordinated debt-holders and long-term senior debt holders of the failing institution would be "absolutely" barred from receiving any payments as part of a dismantling of the company. Other creditors, such as derivatives counter-parties, would be eligible for taxpayer-funded payments; still, all creditors would have to absorb losses in any liquidation process of an institution: "In no event may taxpayer money be used to cover losses associated with the failure of a large financial firm," states the FDIC proposal.  Also secured creditors will only be protected based on the value of their collateral, the rule pointing out that illiquid collateral used to secure short-term liabilities were a major contributor to the financial crisis.

The FDIC's new power for orderly liquidation authority has been sought by FDIC chairman Sheila Bair since the 2008 credit crisis as a means to avoiding dumping taxpayer dollars into troubled financial companies. She said before Congress in September that FDIC is authorized to write 44 new rules on how it would carry out its role under the new reform. So this rule is just one part of a bigger effort by the agency. It is the first step in giving market participants better transparency and confidence about how certain key components of the resolution authority will be implemented. Shareholders and unsecured creditors should understand that they, not taxpayers, are at risk, FDIC chairman Sheila Bair said in the statement.

Critics argue that this so-called "resolution authority" will encourage institutions to make risky investments with a mega-bank, in detriment of mid-sized/small banks, because they know they could be partially bailed out upon its failure. But Bair said that the authority to differentiate among creditors "will be used rarely" and the kind of creditors that would receive greater funds could be those that provide building maintenance or information service technology to the company so they can keep it operating. Moreover, how creditors are treated under the new resolution authority would closely match how they are treated under bankruptcy proceedings. She also said that the option of providing additional payments to some creditors was so the FDIC could prevent a disorderly collapse of the big bank while the agency seeks to sell assets and recover costs.

The hope is that in early 2011 the agency will begin working on rules to identify what assessments big banks would be charged to recoup any taxpayer funds used when dismantling a failing mega-bank.