In the 2008 financial crisis, the US government had limited options: Either bail out large, interconnected financial firms that were failing — or risk widespread financial instability. It had little choice but to opt for the former.
After the crisis, banking regulators wisely made the megabanks more resolvable, through separability requirements established in so-called living wills and by requiring them to hold sufficient capital to ensure they could survive crises (known as “total loss absorbing capacity,” or TLAC).
Because of these changes, it would now be possible to break up a megabank in severe distress. But a rash of recent bank failures shows we need to extend these requirements to all large banks, not just the very biggest ones. Fortunately, the Federal Deposit Insurance Corporation is holding a board meeting today to propose new rules for expanding the number of banks required to meet the new requirements.
I’ve seen firsthand what can happen when financial firms collapse in total disorder. In 2008, I was at the Treasury Department working to wind down American International Group. After the firm had been bailed out and stabilized, the key question was how the federal government and taxpayers were going to get paid back.
While AIG’s trading unit had made some devastatingly imprudent bets, most of its other businesses were profitable. The solution seemed simple: Break up the firm and sell those businesses as quickly as possible, using the proceeds to pay back the government and taxpayers.
This was easier said than done. AIG’s various businesses were fused together so tightly that it was impossible to break them apart without destroying substantially all of their value. Our options were limited, even in failure. Because of that, the government would not get paid back for years.
What was needed, but not available, was for AIG to be separable — i.e., for its major businesses to be pre-packaged for sale. Had that been the case, AIG could have been broken up relatively quickly, with the pieces sold to help it recover or to facilitate a more orderly resolution. To sell a business, the firm must set up a data room, which supplies the detailed information bidders need. Typically, this is done only when a sale is imminent. Negative surprises can emerge then to frustrate the sale, however, as happened repeatedly with AIG in the crisis.
Doing this work ahead of time can mitigate such risk. As part of a megabank’s mandated living will, it must identify saleable objects — lines of business and portfolios of assets — and prepare the data rooms in advance for their potential divestiture. The megabanks’ recently filed public resolution plans, for instance, identify numerous objects of sale. Making a bank separable is like hard-wiring a self-deconstruct button. It creates realistic options for making bailouts avoidable and mitigating instability when stress and crises hit.
The events of this past spring revealed a gap, however: Large regional banks aren’t subject to megabank resolvability requirements. They don’t have the “bail-in” long-term debt (LTD) or the prepped data rooms that the megabanks do. That’s why when Silicon Valley Bank, Signature and First Republic failed, the government had extremely limited options to prevent financial instability. We need to fix this. Fortunately, we know how.
The LTD and separability/data room requirements, which go hand in hand, should be extended to all banks with $100 billion or more in assets. If SVB had held sufficient capital and been separable, its failure would likely have been far less chaotic. Its loss-absorbing capital — including its LTD — would have ensured that the vast majority of losses would have been borne by the bank’s investors, not the FDIC’s deposit insurance fund. Quickly and systematically selling or breaking up SVB, the first of these banks to fail, would have minimized uncertainty for the entire banking sector.
Going ahead, Washington must ensure that all large banks have sufficient private loss-absorbing capacity. This is why I have advocated for the joint Federal Reserve-FDIC notice of October 2022 for proposed rulemaking on LTD to require “large banking organizations to improve the prospects for the orderly resolution … should they fail.”
Equally important is ensuring separability. As a member of the FDIC board of directors, I will be paying special attention to the agency’s Title I review of megabanks’ separability capabilities and associated legal-entity rationalization. Independently verifying that the megabanks’ self-deconstruct buttons will work is critical — but so is expanding those data room requirements to ensure separability of all banks with over $100 billion in assets.
Fifteen years ago, we all witnessed the damage and unfairness of bailing out banks considered too big to fail. We now know what it takes to make them safe to fail. Ensuring that all large banks can be broken up in an orderly manner helps ensure that we won’t be forced to make a choice between bailouts and financial stability when the next crisis hits.
Michael J. Hsu is the acting U.S. comptroller of the currency.
This column was provided by Bloomberg News.