May 25, 2017

Eliminating Dodd-Frank's Overrated Escape Hatch

Hester Peirce

Former Senior Research Fellow
Summary

If the OLA is removed from regulators’ toolbox, other regulatory reforms can address the concerns that led to the decision to include the OLA in Dodd-Frank.

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As Congress debates financial reform, one piece of Dodd-Frank that is potentially on the chopping block is the Orderly Liquidation Authority (OLA)—a mechanism to wind down large financial institutions. As with many other parts of Dodd-Frank, its inclusion in the law is an understandable reflection of the time at which it was written. Since then, however, we have had time to rethink the wisdom of the provision. It is time for the OLA to go away.

The OLA was a response to dramatic financial firm failures during the crisis, especially Lehman Brothers and AIG. The bankruptcy of the former and the bailout of the latter left people looking for a better way. Dodd-Frank’s drafters believed that the OLA, which is intended to offer an alternative to bankruptcy and bailouts, was the answer.

The OLA offers regulators the option of managing the liquidation of failing financial firms that—in the words of the statute—“pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.” The default remains bankruptcy, but regulators have broad authority to invoke the OLA. Under the OLA, the Federal Deposit Insurance Corporation steps in as receiver for the company. The FDIC has broad authority to run the company, sell assets, favor certain creditors, and repudiate contracts. To fund a resolution, it can draw on Treasury funding.

Uncertainty is problem number one with the OLA. A company’s creditors and other counterparties cannot plan ahead because they don’t know what the rules of the game will be if the financial company runs into trouble. The company might go through bankruptcy, or it might be put under the OLA, which could proceed according to different priorities and procedures than would govern a bankruptcy. Government officials decide—based on a conveniently malleable set of criteria—whether to use the OLA. A firm’s creditors are not allowed to challenge that decision.

Problem number two is that the OLA could become a bailout mechanism. The OLA offers regulators a space within which they can provide bailouts without appearing to be doing so. The OLA grants some creditors favor over others, which could facilitate a bailout of a particular creditor or class of creditors. Moreover, Dodd-Frank authorizes Treasury to lend the funds necessary to carry out a resolution. While the statute requires that systemically important financial companies be assessed to pick up any resolution costs that are not covered by the failed financial firm’s assets, the government may be reluctant to conduct such assessments during a time of financial stress. In any case, it is not clear that well-run systemically important financial companies should bear the costs of resolving failing financial companies.

The third problem is the poor track record of the Federal Deposit Insurance Corporation, the agency charged with running OLA resolutions. As Dodd-Frank was being written, the FDIC argued in favor of the OLA as a natural extension of its pre-Dodd-Frank authority to resolve failing insured banks. The FDIC’s record in handling failing banks, however, is not particularly compelling. The FDIC’s deposit insurance fund often picks up a large part of the tab. Last month, for example, the FDIC and a state regulator closed First NBC Bank in New Orleans. The FDIC estimates that the cost to the deposit insurance fund of that bank failure will be almost $1 billion, which makes it the eighth largest hit to the fund, according to reporting by the Wall Street Journal.

The FDIC contends that the way in which it resolves a bank is only marginally relevant to how much a failure will cost, but the challenges the FDIC faces in managing and minimizing losses in bank resolutions are likely to be even larger for OLA resolutions. The costly failure of First NBC—a small bank (under $5 billion in assets)—took place in a period of relative calm. Resolving several, sprawling, complex financial companies through the OLA would be a much more challenging task for the FDIC. As Paul Kupiec of the American Enterprise Institute explains, “It is improbable that the FDIC staff would have the capacity to manage multiple [OLA] resolutions simultaneously.”

These problems and others, such as questions about the OLA’s constitutionality and the workability of the FDIC’s planned approach for exercising its authority, suggest that the OLA is not the right way to address large financial firm failures. If the OLA is removed from regulators’ toolbox, other regulatory reforms—including improving bankruptcy, a predictable, time-tested, transparent mechanism for dealing with failing firms—can address the concerns that led to the decision to include the OLA in Dodd-Frank.