House leadership may make bank-failure risk more widespread
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As an attorney who has worked in the failing bank arena for many years, it is somewhat perplexing why the current House leadership appears intent upon eliminating the FDIC’s Orderly Liquidation Authority (OLA) set forth at Title II of the Dodd-Frank Act. On Friday, the president signed an executive order directing the Treasury secretary to analyze the benefits and risks to the financial services system by retaining or abandoning the OLA.

It is strongly suggested that the OLA is a potentially valuable tool for the FDIC in a systemic failing bank scenario and should be preserved.

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Starting out with some basic facts, the FDIC is quite capable of handling the majority of the 5,848 U.S. banks that might fail without being required to utilize the OLA. Except for approximately 35 of the largest banks, designated as Systemically Important Financial Institutions (SIFIS) with assets exceeding $50 billion, the FDIC has ably demonstrated its capability of resolving smaller-sized banks through the prudent use of the Deposit Insurance Fund.

 

In point of fact, only in the case of Washington Mutual has a bank failure occurred in which the bank held more than $50 billion in assets (It should be noted that the primary reason that Washington Mutual failed was not its capital condition; it was a liquidity failure.)

With very minor exceptions, the FDIC has been able to employ non-OLA resolution tools, such as purchase and assumption agreements, to protect the interests of all depositors, including those whose deposits exceed the general deposit insurance limit of $250,000.

Even in the case in which a smaller SIFI might fail, the non-OLA FDIC authority should be sufficient, rather than utilizing the OLA, because, while many smaller SIFIs have large balance sheets, they lack the complexity presented by the 10 largest banks and bank holding companies. For example, the 10 largest U.S. banks hold $8.3 trillion of deposits out of a total $12.9 trillion.

For this category of very large institutions, the OLA is of critical importance to protect against systemic failure. Essentially, the OLA allows the FDIC to seize an entire holding company structure and reorganize it using a bridge bank or bridge company structure that results in the recapitalization of the holding company’s subsidiary bank (at the expense and loss to the shareholders of the holding company).

Among other things, should the FDIC use the OLA, it is authorized to borrow from the U.S. Treasury to effect a reorganization transaction. Importantly, any borrowing is actually owed by the remaining SIFIs, and must be repaid through assessments imposed by the FDIC.

For some unexplained reason, the leadership in Congress is enamored with substituting the OLA for a new Bankruptcy Code chapter, which would allow a failed holding company to be resolved through the bankruptcy courts.

Anyone who is familiar with a complex bankruptcy proceeding recognizes that any such proceeding would not occur quickly and would permit creditors and other counterparties to mount numerous legal challenges that are obviated by the use of the OLA.

Is it possible that there are circumstances in which a holding company could be reorganized through a bankruptcy process because the holding company’s assets are primary residing in the subsidiary bank? Clearly, yes, and the current OLA requires that this be considered prior to exercising the OLA.

However, in regard to the very largest SIFIs, the challenge of managing such a reorganization through bankruptcy would be daunting — and would likely cause the markets to constrict in a manner that could develop into liquidity crises similar to those experienced in the last financial crisis.

While the FDIC may not be up to the task of handling the failure of a large systemic SIFI, deleting the OLA is an approach that eliminates a necessary tool from the FDIC that, in the proper circumstances, could avoid systemic contagion among the remaining larger SIFIs (as well as other financial industry counterparties).

Considering that the Treasury secretary would be directly involved in the determination whether to exercise the OLA in any failure situation, adopting a bankruptcy option while preserving the OLA would increase rather than decrease the likelihood of avoiding a systemic failure.

 

Joseph Lynyak III is a partner in Dorsey & Whitney's Finance & Restructuring Group and a member of the Banking Industry Group. He practices in both the firm’s Washington, D.C. and Southern California offices. Lynyak possesses expert knowledge on foreign and domestic banks, savings associations, bank holding companies, finance companies, mortgage banking companies and their subsidiaries and affiliates.


The views expressed by contributors are their own and not the views of The Hill.