Does the Obama administration’s open-ended financial regulatory proposal get us out of the troubled bank woods? Not by a longshot. With TARP being repaid, toxic asset plans shelved, and the financial system getting a second wind, it’s tempting to ignore the issue of bank wind-downs. This is done at our peril. A sharper eye is needed not only toward future crises, but also to certain financial institutions that even today look more like the walking-dead than the fast-sprinting. Mo’ better regulatory handling of wind-downs (or resolution authority, as this is more formally known) is needed, given their threats to the financial system, their apparent undermining of sacrosanct property rights and the crisis-ridden environment of bank collapse. As unfolding litigation, emerging disclosures and conveniently timed just-in-time regulation in Europe show, these issues are poignant ones that the current proposal falls short on.

The authority to wind down banks is also known as “resolution authority.” This authority allows government regulators to seize company assets and divvy them up among a group of claimants in priority order, all of which seemingly undermines sacrosanct private property rights. Frequently last on the list are the original equity holders. Ahead of them in queue stand creditors and the government agency itself. This has led to litigation that, thus far has proven fruitless. Courts regard financial institution resolution as a species of bankruptcy. Under its bankruptcy power, the government may readjust the rights of private parties to more fairly distribute loss. Generally, this is not viewed as an unconstitutional taking. Resolution authority already encompassed large groups of banks, but recent moves in the UK, Germany and, now, the U.S. promise to capture an even larger group of institutions in its (safety) net.

The present crisis has supplied a wealth of disclosure about FDIC bank resolution operations. For example, in a recent 8-K R&G Financial described the consequences of its bank subsidiary Premier Bank losing its status as a “well capitalized” bank. “An ‘adequately capitalized’ bank must obtain a waiver from the FDIC in order to accept, renew or roll over brokered deposits.” The FDIC may, however “deny permission, or revoke previously granted permission, or may permit Premier Bank to accept fewer brokered deposits than the level considered desirable.” The situation is more serious for the bank sub of People’s Community Bancorp “On June11, 2009, Peoples Community Bank, the wholly-owned banking subsidiary of Peoples Community Bancorp, Inc., consented to a Prompt Corrective Action Directive issued by the Office of Thrift Supervision. The Directive requires the Bank, among other things, to take one of the following actions to recapitalize the Bank by June 30, 2009: (i) merge or be acquired by another financial institution, financial holding company, or other entity; or (ii) sell all or substantially all the assets of the Bank to another financial institution, financial holding company, or other entity.”

The resolution authority outlined in yesterday’s proposal is a long way from becoming law and there doesn’t appear to be any disclosure about risks that would be presented were that to happen. There are, however, examples that describe, in broad detail, the risk of government intervention in the private market. In a recent prospectus, DWS Variable Series I warns investors that “[s]ome governments exercise substantial influence over the private economic sector […] In adverse social and political circumstances, governments have been involved in policies of expropriation, confiscatory taxation, nationalization, intervention in the securities markets […] and imposition of foreign investment restrictions.” DWS’ disclosure is refreshingly candid. Most disclosures about the risk of government expropriation have a kind of banana republic qualifier – referring to the risk of operating in “emerging” or “developing” countries. A recent Citigroup Free Writing Prospectus, for example, warned: “[i]nvesting in emerging market countries involves a greater risk of loss due to expropriation, nationalization, confiscation of assets and property or the imposition of restrictions on foreign investments.”

These concerns arise for good reason as equity holders find their once-prized holding to be worthless. Most glaringly in the U.S., a group of investors sued JP Morgan Chase, in Texas state court, over Morgan’s FDIC-brokered acquisition of Washington Mutual (American National Insurance v. FDIC, 09-00044, American National v. JP Morgan Chase, Galveston County Court, 09-0199). The investors argued that JP Morgan had defrauded them by talking down the value of WaMu’s assets prior to the sale. The FDIC intervened. The agency maintained that the suit was essentially a challenge to decisions made by the FDIC receiver and was subject to a jurisdictional limitation added to the FDI Act by the post-S&L-crisis law the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). The case is still in the middle of that jurisdictional wrangle. It has been removed to the U.S. District Court for the Southern District of Texas which is currently considering an FDIC motion to remand the case to the D.C. District Court.

Also involved in systemic risk control will be a new regulatory body called the Financial Services Oversight Council (FSOC).  The FSOC replaces the President’s Working Group on Financial Markets.  Like the PWG, the FSOC will be composed of the heads of various regulatory agencies, including two new agencies.  The white paper speaks in mushy generalities about the FSOC’s role – it will “facilitate interagency discussion.”  Unlike the PWG, it will have permanent offices and limited regulatory power.  It is empowered to recommend firms for classification as Tier 1 FHC supervision.  It will also “have the authority … to require periodic and other reports from any US financial firm.”

With Wednesday’s announcement by Secretary Geithner, these issues seem destined to expand.

The administration’s white paper, “Financial Regulatory Reform: A New Foundation,” lays out a new resolution regime that would apply to bank holding companies and to other institutions classified “Tier 1 Financial Holding Companies.” Tier 1 FHC companies are those that, under the new proposal, would be subjected to a more stringent regulatory framework because they pose risks to the financial system generally.

Because the resolution power is “only for extraordinary times,” it is “subject to very strict governance.” It works like this: if the Treasury, the FDIC, the Fed, or (in the case of securities dealers) the SEC, determines that a bank holding company or a Tier 1 FHC is in default or in danger of defaulting and that the failure of that institution would have adverse effects on the financial system, the agency can ask Treasury for a resolution order. Treasury must then run all over Washington getting written approval from 2/3 of the Federal Reserve Board of Governors and either 2/3 of the FDIC, or 2/3 of the SEC Commissioners, or the approval of the (new) National Insurance Commissioner.

Once Treasury has all its paperwork in order, the white paper says it “should” appoint the FDIC as receiver (or, in the case of a securities dealer, the SEC). The FDIC may then employ a familiar-looking resolution toolkit (conservatorship, receivership, the ability to make loans, purchase assets, guarantee loans, or buy equity) to resolve the institution. Instead of being subject to the “least cost” standard of the FDI Act, the white paper asks the receiver to consider effectiveness, cost to taxpayers, and moral hazard when designing a resolution strategy.

The FDIC’s resolution process is paid for out of the Deposit Insurance Fund. The new resolution process has no such funding. Instead, the White Paper says the FDIC should “when necessary” borrow money from Treasury. Treasury would be empowered to issue debt to finance the loans.

The resolution authority plan is based on powers granted to the FDIC by the Federal Deposit Insurance Act. That mechanism works like this: if a bank’s chartering authority (state bank regulator, OCC, or OTS) deems the bank insolvent, the chartering authority has discretion to close the bank and appoint the FDIC as receiver. The FDIC takes control of the bank and it may by liquidate assets, satisfy claims, and use stop-gap devices such as conservatorships.  Section 11(c) of the FDI Act also provides that the FDIC may liquidate or wind up the affairs of the bank. The FDIC must choose the option that will impose the least cost on depositors, investors, and the deposit insurance fund.

The National Depositor Preference Amendment to FIRREA establishes the following claim priority: 1. expenses of the receiver; 2. insured deposits; 3. general or senior liabilities; 4. subordinated obligations; 5. shareholder claims.

The U.S. is faced with an important regulatory gap, due to its patchwork system for bank creation and regulation. The FDIC process can only be used on banks that contribute to the Federal Deposit Insurance Fund. Therefore, FDIC resolution can be used for deposit taking banks, but it doesn’t apply to their parent organizations regulated by the Bank Holding Company Act or complex entities like AIG. If a diversified institution like Citigroup were to fail, the FDIC’s resolution authority would only be partial, leaving the remainder either to other regulators or the standard bankruptcy process. Such a situation would lead to confusion, turf battles and painfully a drawn-out resolution period. In Citi’s case, many regulators would descend on it: bank subs would be seized by the FDIC, broker-dealer subs by the SIPC, and the holding company could file for bankruptcy. Yesterday’s proposal would allow the government to unwind such institutions in an orderly way instead of facing the Hobson’s choice of propping them up (such as AIG), or letting them collapse (like Lehman Brothers).

While the U.S. has been able to take its time arriving at these proposals, others have not. In the case of certain events abroad, looming institution failures led to hastily concocted laws and irate investors. In early 2008, for example, the English government, acting without support from the Conservative Party, passed the Banking (Special Provisions) Act. The Act gave the UK Treasury power to seize a wide range of assets from a bank, if doing so would help maintain “the stability of the UK financial system.” This power was dubbed the Special Resolution Regime. Just in time, as it turned out, as a few days after enactment, the Treasury ordered all the securities of the failing Northern Rock Plc bank transferred to the Treasury Solicitor. The Act gets around the expropriation problem by requiring HM Treasury to get an independent valuation and create a “compensation scheme” to reimburse the former owners. Within a few weeks, Northern Rock’s compensation scheme began paying shareholders as little as 5 GBP per share.

Like their U.S. counterparts suing over WaMu’s seizure, two hedge funds holding most of Northern Rock’s securities, SRM Global and RAB Capital, took heavy losses. The funds challenged the compensation scheme, arguing that it amounted to expropriation without compensation and thus violated Article 1 of the EU Convention on Human Rights. Essentially, the Act imports bankruptcy law into its scheme because it requires that former asset holders receive only the value their investments would have had if the bank became insolvent. Successive courts have found that Northern Rock’s equity securities were worth “nil or a derisory sum.” The case is still active. It was recently argued before Court of Queen’s Bench in London, sitting en banc.

Germany, too, enacted a clutch-play resolution law. In late 2008, the German government passed the Financial Market Stabilization Act, which created the Financial Market Stabilization Agency. The agency distributes government money through a fund called SOFFIN. SOFFIN began as an investor and guarantor of loans, but when it looked like a major bank called Hypo Real Estate was going bust, the government amended the Stabilization Act to give SOFFIN power to acquire failing institutions. The German law avoids claims of expropriation by not giving SOFFIN any power to seize assets. Instead, the fund buys shares on the open market. Two days after the amendment took effect SOFFIN started buying Hypo shares, offering investors a ten percent premium over the market price, and ultimately acquiring a controlling share. American hedge fund manager and foreign bank aficionado JC Flowers, who owns 14 percent of Hypo, refused the offer. SOFFIN increased Hypo’s share capital, bought all the new shares, and now controls 90 percent of Hypo. Hypo recently announced plans to squeeze out minority investors; Flowers stands to lose a billion Euros.

On the other hand, Canada’s financial system stability has been the envy of other Western economies. Though its instability is hard to ponder, there are rules in place lest a Canadian institution fail. The federal Bank Act empowers the Office of the Superintendent of Financial Institutions (OSFI) to take control of a bank where it has failed to pay its liabilities or will likely not be able to pay its liabilities as they become due and payable. A takeover may also occur when the assets of a bank, or its regulatory capital, have reached a level, or are eroding, in a manner that may detrimentally affect its depositors and creditors. Once OSFI has taken control, it may do all things necessary or expedient to protect the rights and interests of the depositors and creditors. Essentially, the Bank Act allows OSFI to assume the powers of the directors and officers previously responsible for the management of the bank. The Act provides for two resolutions to a troubled bank's situation while under control of OSFI: winding-up or the return of control to the bank over its affairs. Where a bank is wound-up, the expenses resulting from the control of OSFI constitute a claim of the federal government against the assets of the bank that supersedes any prior claim in respect of the shares of the bank.

As the financial crisis winds to a close and markets begin to look up, regulators will be increasingly looking for ways to avoid the next crisis. Resolution authority may very well be one way to preempt the next crisis.

By Craig Eastland

Published: June 18, 2009