How might the liquidation of large, failing firms play out under new rules?
Andrew Metrick, the former Chief Economist for the President’s Council of Economic Advisers, shares his thoughts.
Q: What is the point of the new orderly liquidation process?
Professor Metrick: The goal is to provide an option that would effectively allow “slow failure.” The motivating idea is that no institution should be too big to fail, but some institutions are too big to fail quickly. Orderly liquidation will slow down the dissolution so as to reduce the contagion to other institutions and markets.
Q: Who decides if an institution must enter orderly liquidation?
Professor Metrick: The Secretary of the Treasury and the U.S. Federal Reserve must agree to place an institution into orderly liquidation, subject to a fast judicial review if the institution objects. Depending on the type of institution, the Director of the Federal Insurance Office, the SEC, or the FDIC must also approve.
Q: Describe orderly liquidation.
Professor Metrick: The FDIC acts as the receiver and can choose to transfer some of the institution’s assets and liabilities into one or more “bridge financial companies,” which could then be capitalized (if necessary, and with many restrictions) with funds from the Treasury.
Q: How is that different from bankruptcy?
Professor Metrick: The most important difference is that access to capital will allow these bridge companies to slowly wind down operations, with less incentive or ability for counterparties to run away from the failing institution. For example, unlike in bankruptcy, counterparties in derivatives and repurchase agreements will not be allowed to unilaterally terminate contracts.
Q: Is this a bailout in disguise?
Professor Metrick: No. The Act places restrictions on the ability of the receiver to make payments unless they are necessary for the orderly liquidation, and a proposed rule from the FDIC would interpret these restrictions to include all equity, subordinated debt, and long-term unsecured debt. Furthermore, the Act makes it clear that, in the long run, no creditor may be paid more than any other “similarly situated” creditor. So while bridge payments may help some short-term creditors or derivative counterparties during a liquidity crisis, any excess payments would be “clawed back.”
Q: So what can go wrong?
Professor Metrick: Lots of things. The Act provides guidance and some restrictions to the FDIC as receiver, but the devil will be in the details of the rule-writing. If the final rules give the FDIC lots of discretion (as they have when they resolve small banks) then this new process may increase uncertainty relative to the long history of bankruptcy law. More uncertainty could lead to a higher probability of runs in the first place. If the FDIC limits its discretion with strict rules, however, then smart traders will find ways to game the system. The FDIC is facing a complex rule-making process. It will be some time before we can sort out winners and losers. ■
From Analysis Group Forum (Winter 2011)