How to Avoid Bank Bailouts

CFOs and treasurers who do business with the biggest banks, insurers, and hedge funds may find it comforting if sputtering ones are red-flagged.

The last time the Obama Administration labeled financial-services firms too big to fail, the result was government handouts to prop up sputtering giants like Bear Stearns, Morgan Stanley, and AIG. The latest proposal from President Obama, which he sent to Congress on Wednesday, takes a different approach. Under the plan, if a financial institution runs into trouble and is classified as too big, too complex, and too interconnected with other financial institutions to fail, the government will unwind it and shut it down in what it deems an orderly fashion.

Corporate CFOs and treasurers who do business with the largest banks, insurers, and hedge funds may find that having red flags on those that are in trouble is comforting. Knowing in advance that your financial-services provider might fail would likely be preferable, for example, to the precipitous collapse of Lehman Brothers last fall. An early warning system would help pump up investor and counterparty confidence as well. To be sure, the devil is in the details. But the details are harder to come by than a Republican endorsement of the President’s plan.

Indeed, at a hearing held by the Senate Banking Committee Thursday, most lawmakers were anxious to unearth very basic details: how regulators will define “systemic risk,” how they will determine which companies fall into that category, and what powers regulators should have to deal with these troubled behemoths. But the regulators who testified — Sheila Bair, chairman of the Federal Deposit Insurance Corp.; Daniel Tarullo, a Federal Reserve Board governor; and Mary Schapiro, chairman of the Securities and Exchange Commission — sent the ball back into the senators’ court, saying, essentially, that only Congress can rework the law and establish the necessary guidelines.

Nevertheless, the regulators provided Congress with key concepts that should give lawmakers a start. Under the Obama proposal, any institution that’s determined to pose a systemic financial risk to the United States should be shut down to eliminate any potential domino effect, said Bair.

“The notion of too big to fail creates a vicious circle that needs to be broken,” asserted Bair, who said the shutdown, or “resolution mechanism,” would be similar to a typical Chapter 11 bankruptcy in that the associated losses would be borne by the stockholders and bondholders of the affected company. Senior management would be replaced.

Bair2Bair, Schapiro, and Tarullo testify before the Senate Banking Committee on Thursday.

To further contain the damage, Bair advocated a new rule that would require bank holding companies with subsidiaries engaged in nonbanking financial activities to file a resolution plan with the FDIC that would be updated annually and disclosed to market participants and customers. As another precaution, the largest, most complex financial-services companies — those most likely to pose a systemic risk — would be heavily regulated by the Federal Reserve, and have to submit to a significant amount of stress testing.

In his testimony, Tarullo cautioned lawmakers that shuttering a financial institution in the proposed way should be a rare occurrence. “Chapter 11 is the appropriate route” for unwinding financial and nonfinancial companies. The new regime “should be a discrete mechanism used in unique situations,” he noted.

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