Too Big and Unable to Fail

By Stephen J. Lubben (Seton Hall University School of Law) and Arthur E. Wilmarth, Jr. (George Washington University Law School)

Financial regulation after the Dodd-Frank Act has produced a host of new regulatory tools for resolving failures of systemically important financial institutions (SIFIs). The explicit goal of this new “resolution” regime is to enable SIFIs to go bankrupt without a government bailout, just like other businesses. In our paper, forthcoming in the Florida Law Review, however, we express significant doubts about the new regime’s ability to work as advertised.

The “single point of entry” (SPOE) strategy, which focuses all resolution efforts on a SIFI’s parent holding company, addresses a very stylized, even hypothetical sort of failure. We believe that it is unlikely to work during a global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries.

The Federal Reserve’s “total loss absorbing capacity” (TLAC) proposal is closely tied to SPOE. It would require SIFI holding companies to issue large amounts of debt securities that can be “bailed in” (converted into equity) in a resolution proceeding to make the holding company solvent again. In our view, TLAC debt will also create a new, more opaque way to impose the costs of SIFIs’ financial distress on ordinary citizens, because retail investors in brokerage accounts, mutual funds, and pension funds are likely to be the largest TLAC debtholders.

We propose several strategies for forcing SIFIs and their Wall Street creditors to internalize at least some of the costs of the enormous risks they create. Among other things, mutual funds and pension funds that invest in TLAC debt should disclose the bail-in risks to investors and should include in their offering materials “black box” warnings similar to those already used in selling junk bonds to investors. In addition, each SIFI should describe its resolution plan on a web page that also contains a straightforward discussion of the risks TLAC debtholders are taking on—risks that creditors and counterparties of operating subsidiaries are unwilling to assume. Only with such disclosures can the hazards of TLAC debt be appropriately priced by the market.

The full paper can be found here.