FDIC to Explain How It Will Wield `Too Big to Fail' Power on Wall Street

The U.S. overhaul of Wall Street gave regulators a power they had called for since the collapse of Lehman Brothers Holdings Inc.: the authority to shut too-big- to-fail firms. Now the Federal Deposit Insurance Corp. has to figure out how to use it.

The FDIC, assigned the task of determining how to unwind systemically important, failing firms while avoiding the market turmoil that followed Lehman, will begin explaining plans for the new resolution authority at a meeting in Washington today.

The FDIC, which has protected customer deposits as receiver for failed banks since the 1930s, finds itself in new territory by dealing with the sprawling firms populating Wall Street. The Dodd-Frank law lets the FDIC determine which parts of a failing firm should be kept on life support to stabilize the system and maintain the value of the business line for future sale. It also requires the agency to dismantle and sell off firms it takes over -- a measure designed to eliminate the uncertainty and ad hoc bailouts that came to define the 2008 crisis.

With the new authority, the FDIC “moves into something like Lehman that is a big complicated beast with a lot of arms and legs and heads,” said Mark McDermott, a partner at Skadden, Arps, Slate, Meagher & Flom in New York.

Lehman, facing a liquidity crisis amid losses tied to subprime mortgage securities, filed for bankruptcy on Sept. 15, 2008, after regulators tried to broker an industry-funded solution. The collapse roiled markets as firms lost confidence in counterparties and investors lost faith in regulators’ ability to safeguard their stakes, prompting the government to approve a $700 bailout for financial companies.

‘System Havoc’

If the new powers had been in place in 2008, the FDIC could have moved the Lehman business lines that were still valuable, such as the broker-dealer unit eventually purchased by Barclays Plc, into a separate entity that would have served as a bridge until a buyer was found.

“The inability to close the largest financial companies without creating systemic havoc using the existing tools was underscored over and over in 2008,” said Michael Krimminger, an FDIC special adviser for policy, in a telephone interview.

The FDIC’s authority to choose which creditors would become part of a bridge entity has raised concern among banking officials such as Hamid Biglari, a vice chairman of Citigroup Inc.’s Citicorp unit.

“The lack of certainty with creditors is going to result in a higher cost of funding for U.S. financial institutions,” Biglari told regulators and industry executives at an FDIC roundtable in August, according to a transcript of the meeting.

Priority System

FDIC Chairman Sheila Bair, 56, said the agency has established a clearly defined creditor priority system through its resolutions of depository institutions. The agency will soon propose a rule that would preclude bondholders and subordinated debt holders from being brought into bridge entities, according to an FDIC official who spoke on condition of anonymity because the new rule isn’t public.

The August roundtable was the first public airing of discussions that have been happening at the FDIC for months. FDIC examiners are working with companies likely to be subject to the resolution authority, the agency official said.

Banks have appointed officials to lead compliance efforts, including JPMorgan Chase & Co.’s Melissa Moore, chief executive officer of the bank’s treasury services, and Citigroup executive Zion Shohet.

Under Dodd-Frank, banks are required to submit resolution plans, or “living wills.” Banks will use the plans to determine how “we efficiently turn the keys over” to federal regulators in a financial emergency, said Art Certosimo, a senior executive vice president at Bank of New York Mellon.

Credit Markets

Even as banks plan for the new rules, there’s evidence that the financial industry may not see Dodd-Frank as signaling the end for too-big-to-fail.

McGraw-Hill Cos.’ Standard & Poor’s unit has factored U.S. support for Goldman Sachs Group Inc., Citigroup and Morgan Stanley into credit ratings for the New York-based firms since 2007. Dodd-Frank hasn’t changed that, S&P said in an August report.

If a big bank gets in trouble, “there are many in the market that say, ‘Well, they can’t just walk away,’” Craig Parmalee, an S&P credit analyst, said in a telephone interview.

Krimminger, who is leading the FDIC’s implementation effort, said it’s only a matter of time before banks grasp the government’s intent.

“Through our actions, the rulemakings and the law itself, at some point they are going to realize there really isn’t any other option but to close and liquidate any failed financial company, ” Krimminger said.

One question that won’t be answered in the rulemakings is whether the agency will ever need to use its new power. With the crisis passed and the biggest firms back on steadier ground, some aren’t sure.

“How many times in the history of our nation has the government ever done that?” McDermott said, referring to the 2008 bailouts. “One narrow period in our country’s history. Will it ever need to do it again? I’m skeptical.”

To contact the reporter on this story: Phil Mattingly in Washington at pmattingly@bloomberg.net.

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net

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