Oct. 18 (Bloomberg) -- Federal Reserve Governor Daniel Tarullo said creditors could penalize the largest banks with higher interest rates or desert them entirely if the government doesn’t clarify plans for winding down firms near collapse.
“Unless creditors and counterparties have well-grounded expectations as to how they will be treated in a resolution setting, they may need to charge a premium to compensate for the additional uncertainty,” Tarullo said today at a Washington conference on how to handle failing banks. “In periods of increasing stress in the financial system, they may be unwilling to deal with certain firms altogether.”
Tarullo spoke at the Fed-sponsored conference as regulators weigh how to avert a repeat of the taxpayer-backed bailouts during the 2008 credit crisis. The Dodd-Frank Act requires large lenders to create living wills to describe how they could be wound down in a bankruptcy. If that doesn’t work, the Federal Deposit Insurance Corp. can step in, liquidate the bank and force losses on shareholders and creditors.
Richmond Fed President Jeffrey Lacker told the conference that the Dodd-Frank Act points to unassisted bankruptcy as the “first and most preferable option.”
Still, the memory of economic damage that followed Lehman Brothers Holdings Inc.’s bankruptcy in September 2008 could persuade regulators to choose government-run resolution for the largest banks.
Tarullo said that if creditors and counterparties don’t believe the FDIC can successfully manage a resolution, they may misprice risk by assuming a bailout will result.
“If investors and other market actors think the prospects for orderly resolution seem low, they may assume the firm will be rescued by the government, and any moral hazard present in these markets will continue,” Tarullo said in prepared remarks.
By the end of the year, FDIC Chairman Martin Gruenberg said his agency will seek public comment on a description of its step-by-step approach for seizing a failing firm and capitalizing a bridge company.
The FDIC plan will outline how shareholders and creditors will shoulder losses while the firm’s healthy subsidiaries will continue operating without disruption -- an approach which agency officials have said could work now, even if it hasn’t yet been tested.
One critical component, regulators say, is having enough long-term unsecured debt to convert into equity to help absorb losses and keep a distressed bank running until the firm could be sold or dismantled, known as a “bail-in.”
The Fed and the FDIC will issue a proposal seeking a floor on long-term debt “in the next few months,” Tarullo said.
“This requirement will have the effect of preventing erosion of the current long-term debt holdings of the largest, most complex U.S. firms, which, by historical standards, are currently at fairly high levels,” Tarullo said.
Without a rule, long-term debt levels will probably decline as longer-term rates rise, he said. Regulators have already “seen some evidence of the beginnings of such declines.”
Tarullo, 60, is the Fed governor in charge of bank supervision and regulation and is overseeing the central bank’s implementation of the Dodd-Frank Act. The Fed is the bank holding company regulator and has authority over rules regarding bank capital.
Bail-ins have drawn favor in the U.S. and Europe after taxpayers were forced to bear the risk of rescuing firms such as American International Group Inc. and Royal Bank of Scotland Group Plc while senior bondholders weren’t asked to take losses. Bail-ins have been used in Cyprus, Denmark and Ireland.
Irish banks, which received at least a gross 64 billion-euro ($88 billion) taxpayer bailout over the past four years, inflicted about 15 billion euros of losses on subordinated bondholders, even as senior creditors and depositors were made whole.
The idea of bail-ins has ruffled fixed-income investors. They’re concerned that prices of existing bonds will fall and funding costs will rise if banks are forced to issue more debt, with bondholders used as “the new honeypot” to protect taxpayers, according to a December report by UBS AG analysts led by Robert Smalley.
Wells Fargo & Co., the biggest U.S. home lender, has expressed doubt about bail-ins.
“A good share of our funding comes from deposits,” Chief Executive Officer John Stumpf said May 30 during an investor conference, adding that the bank doesn’t have a lot of debt at the holding company. “I’m hopeful that companies that have a lower risk profile, that have more of their balance sheet funded by deposits, will not be punished by the use of a blunt instrument.”
Citigroup Inc., the bank that took the most U.S. aid during the credit crisis, said it’s better-prepared than some rivals to withstand the impact of new anti-bailout rules that could force lenders to sell more debt.
Citigroup’s disclosures have shown the bank already has issued more long-term debt than some of its largest rivals, Treasurer Eric Aboaf said during an April 22 investor presentation. That leaves the New York-based bank in a better position as regulators decide how much more debt lenders should add to their buffers as required by Dodd-Frank’s Orderly Liquidation Authority, or OLA, Aboaf said.
“Based on what we know now, we believe that our capital structure positions us well to adapt to potential OLA requirements, especially relative to our peer institutions, many of whom tend to run with less long-term parent-company debt than we do,” Aboaf said. Citigroup ranks third by assets among U.S. based lenders.
Tarullo warned that resolution regimes aren’t a panacea because a failure that avoids a bailout still could be costly to economic growth. “Even if a firm is not too big to fail, it may still be of sufficient systemic importance to make its failure a costly event,” he said.
He emphasized that stronger capital and liquidity requirements, and measures to limit run risk in short-term funding markets, are “crucial to a reform agenda.”