Who is Too Big to Fail?: Hearing Examines if Dodd-Frank Authorizes the Break Up of Financial Institutions

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Cmte Financial Services (R)
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Who is Too Big to Fail?: Hearing Examines if Dodd-Frank Authorizes the Break Up of Financial Institutions

Washington, Apr 17 -

After two and half years, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) have yet to clarify their authority under the Dodd-Frank Act to break up large financial institutions, leaving questions as to what their view of this authority is, the Financial Services Committee Oversight and Investigation Subcommittee learned at a hearing yesterday.

Supporters of Dodd-Frank claim this law ended the phenomenon of “Too Big to Fail” by, among other things, authorizing regulators to take certain actions to reduce both the likelihood that a large financial company would fail and the impact of any such failure were it to occur. At yesterday’s hearing, a senior Fed official testified that the Fed has not developed any metrics for determining whether a financial institution poses a “grave threat to the financial stability of the United States” – the term used by Dodd-Frank – and has not yet defined what constitutes a “grave threat.”

“To date, the Fed and the FDIC have not judged a living will deficient. However, certain federal officials have indicated that the Fed and FDIC are prepared to use their authority under section 165 to impose substantive changes on companies’ structures. Relatedly, under Section 121, some have recently argued that the government should order certain large financial institutions to divest assets or operations — i.e., to ‘break them up’ — as a means of further reducing systemic risk. Large banks, they argue, in part, derive an unfair competitive advantage relative to firms that are not deemed too-big-to-fail because their status allows them to secure lower borrowing costs,” said Oversight and Investigation Subcommittee Chairman Patrick McHenry (R-NC).

Section 121 of the Dodd-Frank Act requires the Federal Reserve, after obtaining the approval of the Financial Stability Oversight Council, to order certain financial companies to sell or otherwise transfer assets or off-balance-sheet items to unaffiliated entities if the Fed determines that the company poses a grave threat to the nation’s financial stability and other, less drastic measures are inadequate to mitigate the threat. Some have interpreted Section 121 to provide significant authority to “break up” financial institutions prior to their becoming financially distressed. However, the scope of the Federal Reserve’s authority to do so under Section 121 is uncertain because the Fed has not publicly interpreted the meaning of the provision.

Section 165 of the Dodd-Frank Act requires the Federal Reserve to establish enhanced prudential standards, including requirements for large financial institutions to submit “living wills.,” which are essentially roadmaps for how a firm would be resolved through the bankruptcy process in the event of its failure. The Federal Reserve and the FDIC can restrict a company’s activities or require it to divest assets or operations in certain circumstances if its living will is deficient — that is, if the living will is not “credible” or “would not facilitate an orderly resolution of the company under the Bankruptcy Code.” This leaves many questions as to how the Federal Reserve and FDIC determine whether a living will is “credible” and would facilitate the company’s resolution in bankruptcy.

After yesterday’s hearing, Chairman McHenry explained why the missing metrics for determining whether a financial institution poses a grave threat is important.