The FDIC’s Resolution Problem

By Simon Johnson.  Links to the articles mentioned below are available here:

Under the Dodd-Frank financial reform legislation (Title II of that Act), the Federal Deposit Insurance Corporation (FDIC) is granted expanded powers to intervene and manage the closure of any failing bank or other financial institution.  There are two strongly-held views of this legal authority: it substantially solves the problem of how to handle failing megabanks and therefore serves as an effective constraint on their future behavior; or it is largely irrelevant.

Both views are expressed by well-informed people at the top of regulatory structures on both sides of the Atlantic (at least in private conversations).  Which is right?  In terms of legal process, the resolution authority could make a difference.  But as a matter of practical politics and actual business practices, it means very little for our biggest financial institutions.

On the face of it, the case that this resolution authority would help seems strong.  Tim Geithner, the Treasury Secretary, has repeatedly argued that these new powers would have made a difference in the case of Lehman Brothers.  And a recent assessment by the FDIC provides a more detailed account of how exactly this could have worked (“The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd Frank Act,” FDIC Quarterly, Volume 5, No.2, 2011.)

According to the authors of the FDIC report, if its current powers had been in effect in early 2008, the agency could have become involved much earlier in finding alternative – i.e., non-bankruptcy related – ways to “solve” the problem that Lehman Brothers had very little capital relative to likely losses and even less liquidity relative to what it needed as markets became turbulent.

The FDIC report lays out a series of steps that the agency could have taken, particularly around brokering a deal that would have involved selling some assets to other financial companies, such as Barclays, while also committing some funding to remove downside risk – both from buyers of assets and from those who continued to own and lend money to the operation that remained.  In extremis, the FDIC argues that it could have handled any ultimate liquidation in a way that would have been less costly to the system and arguably better for creditors (who will end up getting very little through the actual court-run process.)

But there are two major problems with this analysis: it assumes away the political constraint and it ignores the most basic reality of how this kind of business operates.

At the political level, if you wish to engage in alternative or hypothetical history, you cannot ignore the presence of Hank Paulson, then Secretary of the Treasury.  Mr. Paulson steadfastly refused, even in the aftermath of the near-collapse of Bear Stearns, to take any proactive or preemptive role with regard to strengthening the financial system –  let alone intervening to break-up or otherwise deal firmly with a potentially vulnerable large firm.

For example, in spring 2008 the International Monetary Fund – where I was chief economist at the time – suggested ways to take advantage of the lull after the collapse of Bear Stearns to reduce downside risks for the financial system.  Compared with the hypothetical variants discussed by the FDIC, our proposals were modest and did not involve winding down particular firms.  Perhaps in retrospect we should have been bolder, but in any case our ideas were dismissed out of hand by the Treasury Department.

Senior Treasury officials took the view that there was no serious systemic issue and that they knew what to do if “another Bear Stearns”-type situation developed – it would be rescue by another ad hoc deal, presumably involving some sort of merger.  (Bear Stearns, you may recall, was taken over by JP Morgan Chase at the 11th hour, with considerable downside protection provided by the Federal Reserve.)

Mr. Paulson was very influential given the way the previous system operates and his memoir, On The Brink, is candid about why: he had a direct channel to the president, he was the most senior financial sector “expert” in the administration, and he chaired the President’s Working Group on Financial Markets.  Under the Dodd-Frank Act, however, he would have been even more powerful – as chair of the Financial Systemic Risk Council (FS0C) and as the person who decides whether or not to appoint the FDIC as receiver. 

It is inconceivable that the FDIC could have taken any intrusive action in early 2008 without his concurrence.  It is equally inconceivable that he would have agreed.

In this respect Mr. Paulson was not an outlier relative to Tim Geithner or other people who are likely to become Treasury Secretary.  The operating philosophy of the US government with regard to the financial sector remains: hands-off and in favor of intervention only when absolutely necessary.

In addition, as a senior European regulator pointed out to me recently, the idea that any agency from any one country can handle a “resolution” of a global megabank in an entirely orderly fashion is quite an illusion.  Similarly, the same person argued, even if we had agreement across countries on how to handle resolution when cross-border assets and liabilities are involved (which we don’t), it would be a major mistake to assume that such resolution would really be without systemic consequences.

These financial firms are very large – more than 250,000 employees in Citigroup currently, operating in 171 countries and with over 200 million clients (according to Citi’s website).  The organizational structures involved are very complex – it is not uncommon to have several thousand legal entities with various kinds of interlocking relationships.

Sheila Bair, head of the FDIC, has herself pointed out that “living wills” for such complicated operations are very unlikely to be helpful (see “Bair eyes tougher rules for big banks,” Financial Times, April 18, 2011).  Perhaps if the financial megafirms could be simplified, resolution would become more realistic.  But any attempt at simplification from the government would need to go through the FSOC and here Treasury has a decisive influence.

And the market has no interest in pushing for simplification – anything that makes it harder to resolve a big bank, for example, will increase the probability that it will receive a “too big to fail” subsidy of some form in the downside scenario.  Many equity investors like this kind of protective “put” option.

FDIC-type resolution works well for small- and medium-banks and expanding these powers could help with some situations in the future.  But it would be a complete illusion to think that this solves the problems posed by the impending collapse of one or more global megabanks.

An edited version of this post appeared this morning on the’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

22 thoughts on “The FDIC’s Resolution Problem

  1. brokering a deal that would have involved selling some assets to other financial companies, such as Barclays, while also committing some funding to remove downside risk

    In other words, transferring the most toxic “assets” onto the FDIC’s — and by inference, the Treasury’s — balance sheet.

    In other words, Dodd-Frank puts the U.S. taxpayer on the hook for the next Lehman. (At least now it’s official.) Which works great, as long as the asset prices recover eventually (cf. RTC). I cannot wait to see what happens when, someday, they don’t.

  2. Simon, if I may, what’s the quarrel about if not the integrity of a whore, Lady Finance, who still doesn’t want to wear protection equipment after spreading an infectious disease through most of the establishment of our little village called Earth?

    Now, some may want to unpack integrity from above, but it comes down in straight lines: integrity of pleasure vs. integrity of judgment. You and other point out that judgment must be impaired when the vaccine is taken by the victims, yet the others argue that freedom of choice and agency of all parties involved in consensual play go well hand in hand.

    The previous entry, posted by James, made me think that it’s the welfare-state liabilities pushing the weaker characters in the arms of Lady Finance. The Darwinian consequences can be postponed for only that long…

    I look forward to Iceland, great case study in progress.

  3. An important point raised here (and in other entries in the past) is that no USA-based regulatory body has the jurisdiction to handle a multinational bank. So either the world community, contrary to all expectation and past history, suddenly sees the light and generates a coherent, all-inclusive regulatory entity (the UN Financial Regulation Agency…), or sage nations, here and there, take the steps they need to take to protect their own.

    Given the difficulty of the former possible solution, I agree with FDR’s notion of separating casino-style investment banking from depositor banking, which would then simply allow the gambling houses to collapse without, hopefully, dragging the good people down with them.

    Are we too far down the merger and acquisition road to ever effect a meaningful separation of these two types of banking?

  4. Simon, wonderful article. If I may say so, I believe that the “illusion” of Dodd-Frank is, quite frankly, now making any kind of meaningful resolution a topic for the blackest of humor. The myth that any of the world’s megabanks could now be resolved in any meaningful way by any government or group of governments is laughable to say the least.

    Sadly, or perhaps, tragically, the failure to have international concensus on meaningful action to constrain the further growth of these behemoths has made our entire global economy as fragile as is even imaginable, and now, perhaps, the stage has been set for this to play out.

    To take this argument a bit further, the fact that the amount of resources needed to stem the 2008 financial tsunami and its widespread and continuing consequences has led us to a point where, everyday, we stand at the edge of an abyss. Just in the US, not only is unemployment leading to vast social destruction for the middle class and those less fortunate, but has broadly constrained the real growth of our economy to the point where even cheerleader Ben in his news conference admitted that the recovery is likely to produce little growth in the economy in the near term. Coupled with a substantial and long term collapse of the real estate and construction markets, increase in basic prices starting to happen, the dearth of resources available in our states (look for massive layoffs in the next 18 months as budgets get drastically pared), and other factors, I find it hard to find any kind of vague light at the lend of an incredibly long tunnel. I keep looking for any real glimmer, but it appears to me that there is far more pending peril than good coming over the next couple of years. All things considered, it is likely that there is another meltdown surfacing just around the corner.

    As you have been wont to mention, we have already missed a massively wonderful opportunity to reign in the financial oligarchs, and the results of this are likely to come to catastrophic fruition.

  5. Once again, a great public service getting this debate out in the open, Simon.

    One has to completely suspend disbelief to believe anyone in the federal government is capable of closing down any of the remaining, massively bloated financial institutions left standing after the carnage of 2008-09.

    The fatal flaw — and it is fatal — in all the logic supporting Dodd-Frank and the presumption the FDIC is capable of winding down any of these institutions is that regulators understand what they are looking at, and what the linkages among these institutions actually mean in terms of the functioning of markets.

    In 2008, when Hank Paulson was the UST Secty, the various agencies of the federal government supposedly had at their disposal everything needed to understand, audit, value, risk-assess, and unwind the failing investment banks and commercial banks. In 2000, Paulson, as CEO at Goldman Sachs, lobbied for and got Congress to pass legislation that resulted in completely transforming how the SEC regulated the then-five-largest investment banks in America. (See ). This resulted in the SEC implementing its Consolidated Supervision of Broker-Dealer Holding Companies ( ), which, required investment banks to specify their value at risk, assets underpinning their balance sheets (including the banks’ self-assigned credit worthiness of these assets), and to essentially act as self-regulatory organizations answering to their SEC regulator.

    Long story short: None of the files supplied to the SEC ever was opened. No one at the SEC had the slighted notion of the toxic waste that was daily bubbling and growing under their very noses. No one at Treasury, save Hank, had any idea that the regultory watchdog at the SEC was not only neutered by this legislation, but that it had been crippled at the gate where it stood guard to the point it could not move at all. What we got was the global meltdown of 2008-09, with Hank at the helm.

    If these banks have any sense, they will do what they did when Hank ran Goldman in the 2000s: Pretend to be afraid of the FDIC and the US Treasury’s assumption of new, far-reaching powers to intrude in their business, pretend to fight it tooth and nail, and frequently protest the government’s neutering of capitalism and intrusion into the markets. If they have any intelligence at all, they’ll feign alarm when the regulators demand more and more detail on their operations. Then, after a year or so of spirited resistance, they can cave to the “will of Congress,” and allow a massive burden to be placed on the geniuses at the FDIC, Treasury, Fed, the Comptroller, …, the whole lot of them … anyone who wants in (the more agencies involved, the more unknowing bureaucrats looking at files they could not understand even on their best day in grad school). Then they can go back to doing whatever they bloody well please right out in the open, because not a soul in the entire U.S. regulatory edifice will have any idea of what they’re looking at, what the risks are that are being piled up, and how to unwind the god-awful mess that’s been created once again right under their noses.

    Party on. The plutocracy knows exactly what to do: Give Washington whatever it wants, because, as surely as night follows day, no one in that town has any idea of what’s going on inside these banks. The SEC’s, Fed’s, Treasury’s, …’s, epic failure leading up to 2008 was prelude to the real disaster on its way. Maybe in 2012 … oh

  6. Simon, to your point re Hank being “the most senior financial sector “expert” in the administration, and he chaired the President’s Working Group on Financial Markets. Under the Dodd-Frank Act, however, he would have been even more powerful – as chair of the Financial Systemic Risk Council (FS0C) and as the person who decides whether or not to appoint the FDIC as receiver”: That role now falls to T. Geithner. Both Timmy and Hank assiduously curried favor with the very folks they presumably regulate(d) (see, for example, re Hank spilling his guts to his former partners during the height of the crisis … no insider-trading tips there huh?), or, just for fun, Timmy’s cell-phone bill and which of his BFFs are on speed dial (“… Lloyd, it’s me … Timmy … gotta sec …”).

    Averting the sort of regulatory and governance failure that brought the world to the edge of collapse is all about who has a seat at the table when decisions are being made and action is taken. Everyone at the table has an agenda, and they all are protecting someone’s interest. The same folks whose hubris and ignorance took the world to the edge of the abyss are still sitting at the same table dealing another hand. And they most surely are not protecting the interests of the folks who will be forced to bail out the institutions they regulate.

  7. As echoed in other comments, the next large financial institution “resolution” will likely wipe out the FDIC insurance fund, so Treasury/taxpayers will be completely on the hook for the bailout (or risk their own savings regardless of where they bank).

    However, since the FDIC is in line to take on resolution duties, it ought to be able to collect “insurance premiums” as it currently does from all FDIC-insured depositary institutions. This premium charge resembles the financial transaction tax/surcharge that has been suggested as a way to reign in runaway finance. That is a mechanism by which the Dodd-Frank pawning off of resolution authority onto the FDIC could actually make a beneficial difference in reducing the severity of the next banking crisis.

  8. “Tim Geithner, the Treasury Secretary, has repeatedly argued that these new powers would have made a difference in the case of Lehman Brothers.”
    Oh, well if he says so…
    Simon, you must be high to quote “turbo tax Timmy” to make your point. The next time he’s right about anything will be the first time.
    Further, you stated that a senior European regulator said that thinking that any agency from any one country can handle a “resolution” of a global megabank in an entirely orderly fashion is quite an illusion and that it couldn’t happen without systemic consequences.
    Again, if a “senior European regulator” says so…
    Simon, the premise of your article may be correct but you’re barking up the wrong tree for answers. These are the very people under whose watch we got to this point.
    The only way for us to minimize these occurrences in the future is to let anyone and everyone fail!! The rest are all details whose importance pale in comparison.
    That way, partners and investors would never let an institution lever up 50:1. Or in Frannie’s case, 100:1. I mean what genius could possibly think that a firm’s assets can never decrease in value by at least a couple percent??

  9. Among Austrians there’s a third view of this legal authority: “it solves the problem of how to handle failing megabanks by socializing losses on the public (even more than before); it therefore serves as an effective stimulant for banks to partake in even riskier behavior”

  10. I heard something that sounds totally absurd. TBTF banks are borrowing money from the Fed discount window at 0% and then lending the money back to the U.S. government with interest [3-4% ?].

    Is this true?

  11. I’ve also heard that after the Cold War the mathematicians and physicists that would have worked for the military went to Wall Street and they created financial products that destabilized economies and national sovereignty.

    It sounds like a conspiracy theory. The plot for some futuristic black comedy.

  12. @ tippygoldeb press:


    This is an old monetary policy fix that typically flies below the radar of the press: essentially allowing banks that have suffered massive distress to borrow at close to zero (real) and lend to the US govt at prevailing long-term rates. This is a risk-free arb that restores liquidity to the distressed bank(s) balance sheets.

    Most of the time, this allowed the banks to re-capitalize themselves and the rest of the world was no wiser. Now, apparently, the word’s out.

    Oh, my …

  13. Yes, it’s true, Tippy (fiat $$$ being issued as *debt* at 4% interest).

    We The Sheeple have to decide how much of everything that once was in possession by the citizens of the USA through honest labour

    is going to be allowed to be deconstructed (for another decade?) and shipped to the Green Zone in Iraq only to end up silent in the dirt when the oil runs out to fuel the *machine* – ’cause you know that they won’t factor in the amount of fuel needed to get back home…derivatives math sure is squirrely…

  14. @ tippygolden press

    A gift that never stops giving…such as a rich aunt or uncle.
    Indeed they borrow at 1/4 pc (holding banks/ fed. discount window status privileges) and lend out at 6% -22%.
    #1) Bank of America (BAC) is the largest credit card issuer in the world (MBNA) *VISA and **MasterCard ($195bn 2010)
    #2) J.P. Morgan Chase (JPMC) is a close second issuing *MasterCard and **VISA ($185 bn 2010)
    #3) Citi (C)____another American bank that closes in at third ($149 bn 2010) – always in the money?

    Ref: CNBC: World’s Top 10 Credit Card Banks/ American Greed Series

    Subsidies were at one time healthy for a *Once* homogeneous United States banking system, until we were blessed with the “Federal Reserve Banking System (FRBS) Act”(1913/ Wilson)
    Ref: The Creature from Jekyll Island: The Federal Reserve___by Griffin

    PS. FDIC premiums should be on, “A Sliding Scale Premiums’ Structure” with a Special Independent Audit Appointee Supervisor (wishful thinking?) on the job 24/7 for each Big Six (or whomever is considered a bank holding company with access to the fed’s discount window).
    Thankyou Simon and James :-))

  15. @ tippygolden press :-))

    Just a few more anecdotes that will get your adrenaline flowing:
    Ref: Term Asset Relief-Fund Program {(TALF)(7/21/10)} FAQ’s

    Ref: “The Difference between TARP (Troubled Asset Relief-Fund Program and TALF (Term Asset-Backed Securities Loan Facility) @ SeekingAlpha (11/30/08)

    Lastly we have an article by Jack Rasmus: “Obama’s Busted Bank Bailout” (3/26/09)…note the “Public-Private Investment Fund (PPIF)”, and the blatant obfuscated nuance of “Obama’s Housing Recovery Proposal (HASP)”. In closing read the conclusion carefully between the lines?
    PS. My own personal take on this fiasco is that of all bailouts it was ***American Express*** that helped America’s small businesses and entrepreneur’s with the greatest of “Fiscal Earnest” through the hardest of times (JMHO)!

  16. @tippygolden press

    “I’ve also heard that after the Cold War the mathematicians and physicists that would have worked for the military went to Wall Street and they created financial products that destabilized economies and national sovereignty.”

    Not exactly. After the Soviets luanched Sputnik in the mid-1950’s, the USA went into high gear on science and math education at all levels. As a result, by the mid-1970’s there was a substantial surplus of mathematicians and physicists relative to the traditional ways such people earned a living. They diffused into many areas: there are a lot of MDs here with this background now, for example. One place they did gravitate was Wall Street. Initially they were greeted there with some skepticism and even suspicion. But as they began to actually make profits by applying their quantitative skills, they grew in numbers and influence. By the 1990’s quantitatively trained financiers were common and influential. I haven’t seen anything conclusive about the extent to which their work and methods contributed to destabilizing the financial system. My best hunch about that is that they played a significant role in the development of the most opaque instruments (e.g. CDOs, credit default swaps), and that ultra-rapid computer-based securities trading also made the system more fragile. But they probably had nothing to do with other contributing factors such as the huge pool of funds seeking AAA-rated investments with junk-bond-level yields, nor the deregulation of the industry, nor the compensation schemes that promoted unreasonable risk taking, nor the fraud committed by the ratings agencies, nor the dysregulation of the system via Basel accords, nor the aggressive promotion of the housing bubble through sales of houses to people with no possibility of paying for them….


    When the biggest, best and brightest investors in the
    world avoid the “bank” stocks because they cannot understand the balance sheets of these “banks” where does that leave the hard-working, uninformed federal employees charged with regulating these “banks?”

    Oh, and here’s the view of the bailouts and banking regulation — including a view on Hank and Timmy — from a former Fed insider:

    For those who don’t know, Vince Reinhart’s a big deal … a lifetime behind the scenes doing hands-on monetary policy work.

    One is left thunderstruck nothing has been done to date. And, we read further still the GOP is still intent on defunding the underpaid, overworked federal agencies that are supposed to make sure the markets function as markets.

    First you laugh … then you keep on laughing.

    Party on, Garth …

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