Banks 'Too Big to Fail,' Bank Shareholders Not

NEW YORK ( TheStreet) -- Shareholders of failing financial holding companies will take it on the chin -- but healthy subsidiary businesses will have a better chance of surviving -- under the Federal Deposit Insurance Corp.'s new resolution authority.

Acting FDIC Chairman Martin Gruenberg says the agency is ready to move beyond its traditional role of resolving failing federally insured banks and thrifts, with staff and processes in place to resolve large failing financial holding companies.

The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 expanded the FDIC's traditional role, to allow the resolution of entire financial holding companies, rather than just subsidiary banks and thrifts, and Gruenberg said at the Federal Reserve Bank of Chicago Bank Structure Conference on Thursday that the agency's new Office of Complex Financial institutions was ready to "monitor risk within and across these large, complex financial firms from the standpoint of resolution," conduct resolution planning for "potential crisis situations," and "coordinate with regulators overseas regarding the significant challenges associated with cross-border resolution."

The largest failed U.S. bank or thrift was Washington Mutual FA, which was shuttered by the Office of Thrift Supervision in September 2008. The failed thrift was the main subsidiary of Washington Mutual, Inc., which continued to exist after the FDIC was appointed receiver and sold Washington Mutual FA to JPMorgan Chase ( JPM) for $1.9 billion, at no cost the deposit insurance fund.

In the long aftermath of Washington Mutual FA's failure, the surviving Washington Mutual, Inc., and its shareholders have fought several court battles, to prevent the approval of the holding company's bankruptcy plan, arguing that the thrift subsidiary should never have been shut down.

The FDIC's new authority to revolve entire holding companies aims to prevent that sort of messy aftermath.

Under its new authority, the FDIC will require much-maligned "living wills" for bank holding companies with total assets of over $50 billion, along with "certain nonbank financial companies," to help the agency manage orderly liquidations in the event of failure.

Subsidiary banks and thrifts with total assets of more than $50 billion will also be required to submit "living wills," and Gruenberg said "these two resolution plan rulemakings are designed to work in tandem and complement each other by covering the full range of business lines, legal entities and capital-structure combinations within a large financial firm." The FDIC acting chairman added that his agency and "the Federal Reserve have started the process of engaging with individual companies on the preparation of their resolution plans. The first plans, for companies with assets over $250 billion, are due in July."

Of course, with holding companies relying on overnight lending for so much of their funding, the FDIC would not have time to plan an orderly resolution and find a buyer like it does for an insured bank and thrift funded mainly with deposits, which further justifying the usefulness of the "living wills."

One of the FDIC's goals in establishing the new resolution rules for holding companies is "accountability, ensuring that the investors in the failed firm bear the firm's losses," and Gruenberg said that a "promising approach" to resolving a large, complex, publicly traded holding company would be to immediately place the holding company into receivership -- wiping out shareholders -- while "maintaining the subsidiary interconnections."

Another goal of the new resolution authority is financial stability, which Gruenberg said would be enhanced, because a failing large financial holding company's "subsidiaries will remain open and operating as going-concern counterparties, and we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal," which will "preserve the franchise value of the firm and mitigate systemic consequences."

Gruenberg also said the FDIC's resolution authority would "ensure that there is market accountability," because its resolution authority for a nonbank entity "does not provide insurance or credit protection for creditors and counterparties, and creditors will always be subject to potential losses."

After a large failing financial holding company is closed, the FDIC under its new authority will set up a bridge holding company, with "some of the debt of the former parent company, which has been left in the receivership, being converted to equity in the new bridge holding company," with the former debt holders -- now the bridge holding company's shareholders -- having "their claims will be written down to reflect any losses in the receivership that the shareholders cannot cover and that, like the shareholders, these claims will be left in the receivership."

To shore up liquidity for a bridge holding company, the FDIC will have access to the Treasury Department's Orderly Liquidity Fund, created under Dodd-Frank. The bridge holding company will be required to pay back the Orderly Liquidity Fund "from recoveries on the assets of the failed firm or from assessments against the largest, most complex financial companies," so that taxpayers won't be left holding the bag.

Following a transition period with a board of directors and senior management for the bridge holding company appointed by the FDIC, the bridge holding company's new shareholders -- the former debt holders -- will be "responsible for electing a new board of directors," which will in turn "appoint a CEO of the fully privatized new company."

"For a variety of reasons, Gruenberg said, "we would like this to be a rapid transition."

-- Written by Philip van Doorn in Jupiter, Fla.

To contact the writer, click here: Philip van Doorn.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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