Tags: banks | Tarullo | Federal Reserve | creditors

Fed's Tarullo Urges Clear Wind-Down Plan So Creditors Don't Shun Banks

Friday, 18 Oct 2013 02:42 PM

Federal Reserve Governor Daniel Tarullo warned that 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 associated with the disposition of their claims,” Tarullo said.

“In periods of increasing stress in the financial system, they may be unwilling to deal with certain firms altogether,” he said at a conference on how to handle failing banks sponsored by the Federal Reserve Board of Governors and the Richmond Fed.

The 2010 Dodd-Frank Act requires large lenders to prepare living wills that describe how they would be wound down in a bankruptcy. Richmond Fed President Jeffrey Lacker said at the conference that the Dodd-Frank Act points to unassisted bankruptcy as “first and most preferable option.”

Still, the devastation on the economy following the bankruptcy of Lehman Brothers Holdings Inc. in September 2008 could force regulators to seek government-directed resolution for the largest banks.

If a financial company’s collapse presents “serious adverse effects on financial stability,” the Dodd-Frank Act provides for so-called orderly liquidation authority, where the Federal Deposit Insurance Corp. could take over a failing institution and liquidate it over time. Management would be fired and losses forced on shareholders as well as creditors.

Manage Resolution

Tarullo said that if creditors and counterparties don’t believe the FDIC can successfully manage a resolution, they may also mistakenly price in a bailout.

“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 the text of his remarks.

“By specifying which financial obligations will be maintained and where the FDIC will look to impose losses, a well-developed approach to resolution can create incentives for private action compatible with the overall aims of systemic firm resolution,” he said.

By the end of the year, FDIC Chairman Martin Gruenberg said his agency will release a written description of its step-by-step approach for seizing a failing firm and recapitalizing a bridge company, and will invite public comments on it.

Shoulder Losses

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.

Regulators are seeking ways to resolve the largest banks if they’re in danger of collapse without resorting to taxpayer bailouts. One option is a so-called bail-in, in which unsecured long-term debt holders would be forced to convert their holdings into equity. This would help recapitalize a distressed bank and keep it running until the firm could be sold or dismantled.

The presumption that holding company capital liabilities would be required in the first instance to absorb losses in a systemic financial firm will be critical in maintaining the confidence, and limiting the run potential, of customers, liquidity providers, and other creditors at the operating subsidiary level, Tarullo said.

Long-Term Debt

The Fed and the FDIC will issue a proposal seeking a floor on long-term debt “in the next few months,” he 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 Impact

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 senior 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’s Status

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.

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Federal Reserve Governor Daniel Tarullo warned that 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.
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Friday, 18 Oct 2013 02:42 PM
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