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FDIC plots demise of biggest banks

By Claes Bell, CFA · Bankrate.com
Friday, May 18, 2012
Posted: 3 pm ET

For a lot of people, JPMorgan's revelation of a huge loss in the derivatives market last week probably stirred up memories of the financial crisis and the massive government bailout of banks that accompanied it.

While the losses aren't an existential threat to JPMorgan, whether the Dodd-Frank financial reform law will actually be able to prevent a future taxpayer-funded bailout of the bank in the event of a more serious loss is a fair question. Many have raised doubts that the FDIC has the ammunition -- and the will -- to shut down a systematically important financial institution, or SIFI, on the scale of JPMorgan, should it become insolvent.

Last week, FDIC Chairman Marty Gruenberg spoke at a Chicago conference on how the FDIC would do just that:

What we envision is a resolution strategy under which the FDIC takes control of the failed firm at the parent holding company level and establishes a bridge holding company as an interim step in the conversion of the failed firm into a new well-capitalized private sector entity. We believe this strategy holds the best possibility of achieving our key goals of maintaining financial stability, holding investors in the failed firm accountable for the losses of the company, and producing a new, viable private sector company out of the process.

That sounds pretty similar to how the FDIC handles a regular old run-of-the-mill bank failure, but Gruenberg pointed out a few differences, and how the FDIC would deal with them:

  1. Problem: The resolution of a SIFI will have to happen much more quickly than a typical bank resolution to preserve the institution's ability to raise funds and to prevent a severe breakdown in international markets. Solution: Place the SIFI into receivership and immediately create a bridge company, placing subsidiaries that are still profitable and capital from the old institution inside.
  2. Problem: Taking apart a SIFI will be much more complicated than a regular bank, because most have hundreds or even thousands of subsidiaries. Solution: Force banks to create a "living will" that will outline how all the subsidiaries can be liquidated.
  3. Problem: A quick sale of the institution's remains, which is how many bank failures are resolved, isn't feasible or desirable, considering it would just create an even larger SIFI for regulators to wrestle with in the future. Solution: Work to create a viable new institution with the healthy parts of the old one, wiping out the old company's stockholders and some of their bondholders in the process.
  4. Problem: SIFIs are several orders of magnitude larger than normal banks, and so their need for liquid cash in order to stay afloat is much larger. Solution: Set up an Orderly Liquidation Fund with money drawn from all the SIFIs.

While all this sounds great, even the FDIC itself admits these plans don't guarantee taxpayers won't be on the hook for another bailout.

Jim Wigand, head of the FDIC's Office of Complex Financial Institutions, was interviewed by this week by Barbara Rehm of American Banker. Wigand says that while the FDIC could probably handle shutting down one or two SIFIs at once, it will probably never be in position to step in if all the biggest banks are threatened at once, as they were during the financial crisis:

"Title II is designed to deal with resolving a SIFI or two. It was not intended to address the failure of multiple companies in the financial services industry because of an economic or financial collapse," he says.

Dodd-Frank cracked the window for future bailouts by allowing broad-based assistance in an economic emergency.

"It is about saving the financial economy, not saving a firm," Wigand says. "What Title II is saying is, 'Let's not save the firm because only by saving the firm can you save the financial economy.' Dodd-Frank flips that around and says, 'If necessary we need to save the financial economy and as a consequence of that you will save firms.'

It's nice to see the FDIC making progress on creating a framework for SIFI liquidation, but until it actually happens, the markets, and many policymakers and taxpayers, will doubt it can be done. Considering that JPMorgan Chase alone holds around $250 billion in FDIC-insured deposits according to Federal Financial Institutions Examination Council, and the FDIC Deposit Insurance Fund held $11.8 billion as of the fourth quarter of 2011, it better be.

What do you think? Will the FDIC be able to take down and liquidate a Chase or Citibank if the time comes?

Follow me on Twitter: @ClaesBell.

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