On Wednesday, the Treasury Department released a much-anticipated report with recommendations on Dodd-Frank Act’s Orderly Liquidation Authority (OLA), which provides for the resolution (closure) of non-bank firms in a crisis.
In a surprise to most observers who expected the Trump Treasury to recommend repeal, the report concluded that OLA reduces the threat of contagion and prevents taxpayer-funded bailouts in cases of extreme financial instability.
This is a relief in a world that lately seems to provide more disruption. Details below.
Good weekends all,
It appears that a key pillar of the Dodd-Frank Act is poised to come out of the Trump administration relatively unscathed.
Here, the Administration and House Republicans find themselves at odds. House Republicans passed HFSC Chair Jeb Hensarling’s Financial Choice Act last spring, which would have repealed OLA entirely.
Treasury insists that bankruptcy is the first priority in addressing a failing firm. A closer look at its new bankruptcy proposal reveals at best rhetoric, and at worst, a petulant lack of understanding about systemic risk with a curious concern about creditors’ rights in bankruptcy
Almost ten months after the House passed the Choice Act, this week’s report makes it clear that OLA will endure the Trump era.
What the OLA Provides
The Orderly Liquidation Authority gives the FDIC the power to put failing financial institutions into a liquidating receivership during times of financial crisis. Under the OLA, loans supplied to the FDIC from the Treasury would be temporary (subject to strict limits) and would be backed by the failing financial institution’s assets, rather than taxpayers.
The Treasury report tacitly acknowledged that swifter action than bankruptcy litigation is necessary to prevent a financial crisis if a systemically important financial institution begins to fail. Under OLA, financial crises can be staved off by acting quickly to contain the systemic impact of a failing institution over a few days, rather than relying on a more lengthy bankruptcy process. The Fed and the FDIC have deeper knowledge of firms and the sector than bankruptcy judges.
Despite its defense of OLA, the Treasury was quick to insist that Bankruptcy is preferred to resorting to OLA. The report outlined a strengthened bankruptcy process but this proposal would have little real impact. Treasury may talk about “bankruptcy first,” but its report does little to change the primacy of the OLA during times of severe economic stress.
How Did This Happen?
The OLA has been a target of President Trump and his administration since the Presidential campaign commitment to dismantle Dodd-Frank. Leading officials through the Administration have recommended the repeal of the OLA. Last year, Vice President Pence’s chief economist Mark Calabria admitted his bias against the authority, remarking that he thought it would make bailouts more likely.
Calabria qualified that statement last May, indicating that the Administration had begun to research whether market participants believe it indeed raises the likelihood of bailouts and that he may reconsider his opposition to the OLA, if the evidence demonstrates otherwise. Wednesday, we learned his conclusion was to leave OLA alone.
Did market participants urge Treasury to hold OLA harmless? Some firms may think OLA necessary to stop a competitor’s failure from imperiling theirs. The Financial Services Roundtable quickly praised the decision, calling OLA “an important tool to ensure economic resiliency, protect taxpayers and codifies that no institution is too big to fail.”
More GOP Discord: Hensarling Upset
The Treasury Report, once looked at as a potential boon for Republican efforts to “dismantle” DFA, is now seen as a bust. House Financial Services Committee Chair Jeb Hensarling commented: “although I have been pleased or even excited about Treasury’s previous reports, this one disappoints.”
The move is yet another sign of discord between the White House and Republicans in Congress. After a series of minor spats, Trump and Republicans were finally able to come together to pass tax reform. Here, it seems cooler heads at Treasury have prevailed with the preservation a vital regulatory tool.
A New Bankruptcy Code
Treasury attempted to placate Hensarling and other Republican critics by claiming it was taking a “bankruptcy first model,” but this amounts to little more than spin. The report proposes a new amendment to the bankruptcy code that would create a new “Chapter 14” bankruptcy process. The process would be designed to unwind large financial institutions that were engaged in substantial amounts of, “qualified financial transactions” such as derivatives, securities, lending transactions, and repurchase agreements.
The new chapter would operate along a two-entity recapitalization model. A corporation filing for bankruptcy would petition a court for approval to transfer its assets to a newly-created bridge company and “leave behind” the claims of both shareholders and capital structure debt. This would include a stay on termination rights of derivative counterparties, and financial liability would rest with financial institutions, shareholders, management, and some creditors. The approach would attempt to appeal to private funding for the reorganization of the failed financial company.
What Happens Now?
While use of Chapter 14 is perhaps imaginable in the case of a one-off bank failure, it would be next to impossible during a period of systemic stress. Treasury claims Chapter 14 would narrow the path to the OLA by making bankruptcy “the presumptive approach for all failed financial corporations.” A closer look at the provision reveals little more than a smokescreen and one that reveals an embarrassing lack of understanding about systemic risk.
Creating a new bankruptcy chapter is far beyond the Treasury’s regulatory capacities and would require legislative change. In previous administrations, a Treasury report would almost certainly be accompanied by supporting legislation by friendly members of Congress. Given GOP hostility to OLA, especially in the House, it is not clear what kind of reception Treasury’s bankruptcy proposal will get across Capitol Hill.
Even in the unlikely event that Chapter 14 becomes law, it is unlikely to have a major impact during a time of systemic stress. The new bankruptcy provision might work for a one-off failure of a given financial institution, but applying it to multiple organizations at once during a severe economic downturn is simply infeasible. OLA is the law of the land, for now.