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AmericasMarch 21 2018

US Treasury shies away from radical overhaul of resolution process

The US Department of the Treasury released a report on February 21 detailing suggested reforms to US bank resolution mechanisms, but the recommendations were more notable for what they do not want to change than what they want to amend. By Justin Pugsley.
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What is happening?

The Orderly Liquidation Authority (OLA) – a mechanism enabling the US Federal Reserve and the Federal Deposit Insurance Corp to deal with failing systemically important banks – should be retained, according to the report from the US Treasury, entitled Orderly Liquidation Authority and Bankruptcy Reform. Not only did the report recommend keeping OLA, it praised many of its designs and functionalities.

Reg rage – acceptance

Why does that seem surprising?

OLA is one of those Obama-era Dodd-Frank-created bodies loathed by the fervently right-wing elements of the Republican party. They are particularly peeved that as part of a bank resolution or recovery, OLA can draw on temporary Treasury credit lines. This must be supported by the bank’s assets – but under certain circumstances such powers make perfect sense, particularly when private funding is not immediately available.

Those on the right also strongly dislike the discretionary powers that prudential US regulators have to deal with a banking crisis. Again, this seems like common sense: banking crises are fast paced, unpredictable and potentially extremely damaging. Giving resolution authorities relatively flexible powers gives them more scope to deal with future banking crises, the shape of which is unknown.

Why is it happening?

Quite simply: politics. The Trump administration vowed to shred Dodd-Frank, but in practice has been reduced to tweaking it, due to the enormous difficulties of getting that through Congress. However, OLA has been a target for some members of the Republican party so the administration has to be seen to be reforming it.

And while the report devotes considerable space to convincing sceptics about the benefits of the current resolution regime, it did throw them some red meat. The most radical idea is a Chapter 14 bankruptcy code, specifically tailored for big banks and borrowed much from earlier proposals made by the Hoover Institution. The Treasury argues this would impose market discipline, curb excessive risk taking and better address moral hazard issues.

The main advantage of the existing banking process is that it is relatively predictable, impartial in settling creditor claims and follows the rule of law. But the Treasury also recognises the current bankruptcy regime simply is not designed to handle the failure of large, systemically important financial institutions. In essence, the proposed Chapter 14 would allow a bank to declare bankruptcy and ask the courts to approve the transfer of most of its assets within 48 hours along with some liabilities to a new bridge company. The court would have to take account of systemic risks in its judgments. It also makes provisions for the involvement of the regulators, particularly the US Federal Reserve, and even foreign regulators, where relevant.

The main focus would be for the shareholders and various creditors in line of seniority to take the hit for a bank’s failure while the underlying key subsidiaries would continue operating normally. Under this arrangement, OLA would effectively be an emergency tool of last resort.  

What do the bankers say?

Banks have not pushed back at the report’s recommendations. The American Bankers Association even welcomed the Chapter 14 proposal, and said failing banks should be able to be wound down in an orderly fashion.

The global banks were relieved that the report did not significantly deviate from globally agreed regulatory principles as it could have seen foreign regulators (especially in the UK, which hosts the world’s largest financial centre) potentially demanding that US-based institutions hold a lot more capital locally – something the Treasury acknowledged.

Will it provide the incentives?  

The report contains lots of technical recommendations that restrict regulators’ discretion and try to make resolution and recovery processes more formalised, rule and market based. They also want to make processes more transparent and fairer to creditors. The danger is this could reduce the leeway that regulators have to manage a serious and fast-paced banking crisis but does give banks, creditors and regulators greater clarity and predictability.

Whereas many technical tweaks will likely be applied, because this can be done at agency level, there is doubt about whether the proposed Chapter 14 code will make it into law due to possible difficulties with Congress. Also, the right wing of the Republican party is not happy with the report, seeing it as still leaving the taxpayer potentially on the hook, even though the US Treasury did well from the 2007-09 bank bailouts.

US Treasury secretary Steven Mnuchin, a former Goldman Sachs banker, tried to balance common sense with politics and in the end has produced a set of recommendations that are unlikely to seriously change the country’s bank resolution processes – much to the relief of US-based global banks and the foreign regulators that also oversee them.

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