Feds try to keep collapsing banks from crashing economy

Financial industry watchers expect that the Federal Reserve and other agencies, sometime near the end of the year, will introduce one of the final pieces of the framework meant to ensure that banks can fail without requiring taxpayer bailouts or crashing the economy.

The measure would require banks to issue a certain amount of long-term debt. That way, if a bank failed, the Federal Deposit Insurance Corporation would wipe out the bank’s existing shareholders and convert holders of the long-term debt into the new shareholders, thereby keeping the bank running without taxpayer funds.

“Rather than the taxpayer writing a check to the institution to keep it going, it’s the bondholders taking losses to keep it going, in addition to the shareholders,” explained Christopher Wolfe, managing director of Fitch Ratings’ financial institutions group.

“We see this potential development as furthering the agenda for at least providing a framework to at least resolve a bank without involving taxpayers,” said Wolfe, who expects the rule to be issued this winter after international regulators discuss a global version of the rule at the G-20 meetings in Australia in mid-November. “They’ll probably wish to move on this sooner rather than later because banks want to know the rules of the game and people want to move forward.”

The 2010 Dodd-Frank financial reform law included several provisions intended to prevent banks from going bust and safeguards to make sure they don’t drag the entire financial system down with them if they do.

In addition to the “living wills” requirement that big banks spell out exactly how they would go through a speedy and orderly bankruptcy if necessary, Dodd-Frank tasked the FDIC with safely closing failed banks without the kind of chaos that surrounded the Lehman Brothers failure in 2008.

During implementation of the law, the FDIC laid out a strategy for shutting down a troubled bank that involves putting its holding company into resolution and then imposing losses on creditors in an orderly fashion. The long-term debt rule, which wasn’t required by Dodd-Frank but has been under consideration for about two years, would facilitate that process by ensuring that a bank-holding company issues enough unsecured debt that could be converted into shares of the post-resolution company.

The requirement also would make banks take on less risk to begin with, said Stephen Miller, an analyst at the libertarian Mercatus Center at George Mason University.

The reason why banks face runs, he said, is because of the mismatch between bank liabilities, which are deposits that customers can demand at any time, and bank assets, which are longer-term loans that cannot be easily exchanged for cash.

Requiring banks to obtain money to fund their lending more through stock and long-term debt that can’t easily be withdrawn “kind of closes that gap,” Miller said. The long-term debt rule effectively would raise banks’ required capital.

It also would give investors in those assets incentive to closely watch what risks the bank is taking on, since “the holders of that debt would know they faced the prospect of loss should the firm enter resolution,” Federal Reserve Governor Daniel Tarullo said in congressional testimony in September.

“This is a step in the right direction,” Miller said.

Nevertheless, the banking industry is sure to have concerns once the rule is introduced.

Some of the bigger questions will involve the size and type of debt required — including what the maturity of the bonds must be, Wolfe said.

Another question is just how much more onerous the rule will be for the biggest banks. Tarullo suggested that the U.S. version of the rule would go beyond the international agreement and be more stringent for the dozen biggest banks.

Those questions will be addressed next year, said Aaron Klein, director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center.

“I would expect a proposal to be issued by the Fed in December after the international framework is put into place in November,” Klein said. “There should be the standard notice and comment period which would take the better part of 2015 and hopefully improve whatever draft proposal is released.”

In addition to the Fed and the FDIC, the Office of the Comptroller of the Currency would be expected to help write the U.S. version of the rule.