A primer on Dodd-Frank’s Orderly Liquidation Authority

The global financial crisis of 2007-2008 revealed severe problems in how the government and markets cope with failures of financial institutions of all sorts. Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), which created a new mechanism for responding to failing financial institution.

Though Dodd-Frank’s Orderly Liquidation Authority (OLA) was among the most widely supported and bipartisan portions of the bill, passing the Senate by a vote of 93-5, it has subsequently become more controversial. The House Financial Services Committee has approved legislation repealing this portion of Dodd-Frank, and the full House is expected to do the same in early June. How does OLA work? Why is it controversial? What impact, if any, does it have on the federal budget?

The FDIC’s limitations pre-financial crisis

After the Great Depression, the government created the Federal Deposit Insurance Corporation (FDIC) to manage failing banks and protect depositors. The FDIC, in conjunction with the bank’s primary regulator, determines when a bank has failed. Banks do not go into bankruptcy, but rather are taken over by the FDIC.

The FDIC’s first responsibility is to protect depositors, who are insured up to $250,000. The FDIC gives depositors full access to their insured funds immediately, then manages the rest of the failed bank’s assets to minimize costs to taxpayers and maximize returns to depositors with uninsured deposits and other creditors. To pay for this, the FDIC collects fees from banks that are pooled into the Deposit Insurance Fund (DIF). The DIF is pre-funded; it sits on the federal government’s books and provides the FDIC with ready resources. Should the DIF run dry, the FDIC may borrow from the Treasury, which is then repaid by future assessments on banks.

Before Dodd-Frank, the FDIC’s authority was restricted to commercial banks, not to investment banks, insurance companies or other systemically important financial institutions (SIFIs). This worked well until the 2007-2008 financial crisis, when a couple of large investment banks (Lehman Brothers, Bear Stearns), and then a large insurance company (AIG), failed. These three companies were not commercial banks and were not eligible for FDIC receivership. As such, they could either declare bankruptcy (as Lehman Brothers did) or receive emergency aid from the Federal Reserve (as Bear Stearns and AIG did).  Other large, complex financial firms that were the combination of commercial and investment banks (e.g. Citigroup, Bank of America Merrill Lynch) came close to failing and ended up with temporary taxpayer support.  All this exposed the holes in the system for managing—“resolving” —financial institutions that run into trouble, particularly at times of severe financial stress.

How Dodd-Frank extended FDIC authority to resolve failing non-commercial banks

Dodd-Frank extended the FDIC’s authority to resolve failed institutions beyond commercial banks to include the entire bank holding company and all firms designated as Systemically Important Financial Institutions (SIFIs). Thus, if a large, complex financial institution were to fail, the FDIC would have authority to resolve the entire institution, both the commercial bank and the rest of it.

The FDIC needs access to cash to operate these firms while they go through resolution.  Title II of Dodd-Frank created a new fund, the Orderly Liquidation Authority (OLA), to be funded by complex, large institutions and non-bank SIFIs. Unlike the DIF which is pre-funded, OLA is funded only after a failure. The Treasury lends the FDIC money to resolve the institution. If there is a net cost, the FDIC then recoups the money spent by imposing a fee on surviving large, complex financial institutions. In order to invoke the OLA, the FDIC needs the agreement of the Federal Reserve Board of Governors (by a 2/3 majority) and the Treasury Secretary, who is required to consult with the President.

Because OLA has never been triggered, we don’t know if it will work as designed. The FDIC has created a detailed plan on how it would resolve these types of institutions under a scenario called ‘single point of entry’ (SPOE). Under SPOE, the FDIC is appointed as receiver of the top-level holding company, allowing all of its subsidiaries (the commercial bank, investment bank, broker-dealer, insurer, etc.)  to continue operations. The FDIC would then establish a bridge financial company to which the FDIC would transfer the assets and some of the old firms liabilities. The new company would be capitalized by converting a pre-arranged class of debt, which is structured to convert into equity. With equity and limited liabilities, the new firm should be able to access financial markets to fund operations. However, if markets are frozen or otherwise inaccessible, the FDIC could use OLA to lend to the new company.

The FDIC and the Fed have issued various regulations to implement the structure. Large, complex financial institutions have begun to implement these rules. Similar structures of pre-issued debt that could be ‘bailed in’ to support a failing firm have been adopted by other major nations, including in Europe, Switzerland and the UK.

Criticisms of OLA and how it would be implemented

This sounds good, so why has it become controversial? There are three main criticisms of this approach: that it creates a moral hazard; that it gives the FDIC too much discretion in a crisis, and therefore is unpredictable; and that bankruptcy is better.

The moral hazard argument takes issue with the fundamental concept of OLA: Because the law gives the government the authority to resolve a failed entity, it encourages investors to take more risks in lending to these institutions, perpetuating a problem known as “too big to fail.”–the expression used for when a financial firm’s likelihood of being bailed out by the government is widely assumed, giving it a competitive advantage. Those who cite the moral hazard argument contend that companies are incentivized to become SIFIs or large enough banks to qualify for OLA because the market would provide them cheaper cost funding. Notably, however, there are several real-world examples of companies doing the opposite: Met Life fought SIFI designation legally; General Electric successfully sought to escape SIFI regulation by restructuring itself to become smaller and therefore ineligible. Additionally, some studies by the Government Accountability Office (GAO) and others have failed to find market based discounts for large, complex financial firms as a result of the so-called too big to fail advantage. Critics who are the most concerned about this argument tend to support full repeal of OLA.

The next argument against OLA focuses on deficiencies in the FDIC’s implementation plan. The complaints are that nothing requires the FDIC to use SPOE when a crisis hits; the FDIC could take alternative action that could result in creditors being treated differently than they anticipated. Proponents of OLA argue that this critique can be addressed by means other than OLA repeal.

Finally, critics argue that a strengthened bankruptcy code may work better for some types of large, complex financial institutions in some scenarios—and in fact a proposal to extend bankruptcy to work better for complex financial firms, The Financial Institutions Bankruptcy Act of 2017, has been introduced in Congress, gained bipartisan support, and already passed the House of Representatives.

The argument behind strengthening bankruptcy code is that the existing code has a series of gaps that make it difficult to resolving large, financial corporations, and that many of these gaps can be addressed by adding a new section of the bankruptcy code (sometimes referred to as Chapter 14).

Proponents of OLA would argue, however, that bankruptcy assumes some other entity can provide so-called debtor in possession (DIP) financing—financing that allows the failed company to continue to operate and re-emerge post-bankruptcy—and that such an action is difficult for banks to undertake as they are typically the DIP financers themselves. That is, though most major U.S. airlines and many other household corporate names have gone through bankruptcy, the process is less straightforward for large banks and financial institutions, particularly during a financial crisis when the failure is widespread across institutions. Without the government to provide DIP financing when the financers themselves can’t, who can?

It’s also important to note here that using the bankruptcy code to handle the failure of a large, complex financial firm is actually in-line with another part of Dodd-Frank that mandates that large, complex banks and SIFIs have “living wills” that demonstrate the firm’s ability to declare bankruptcy, not trigger OLA. Under Dodd-Frank, the bankruptcy code is the first option for a failing financial firm, leaving Title II and OLA as a last resort.

Fiscal implications of OLA

If the FDIC taxes surviving financial institutions to cover any losses in incurs in resolving a failed institution, why should there be any implications for the federal budget? Would repealing Title II actually save taxpayers money?

In reality, the answer is no, but in government accounting, the answer is yes because the official scorekeepers in Congress look at everything through a ten-year window. They estimate that repealing Title II would save $15 billion over ten years. Essentially, that estimate assumes that OLA will be invoked over the next decade and that during that period, the FDIC will spend more money than it takes in—even though the law requires that the fee levied on financial institutions covers all the FDIC’s expenses.

The true cost to taxpayers from OLA is zero, although over an arbitrary ten-year period it may be counted as having a cost. Thus, if OLA is counted as increasing the deficit over a ten-year period, repealing OLA is counted as reducing the deficit.

The CHOICE Act and OLA repeal efforts

Repealing OLA is likely to be considered by the House of Representatives in the first week of June as part of the CHOICE Act, legislation introduced by House Financial Services Chairman Jeb Hensarling (R-TX). This legislation passed Committee on a party-line vote and although passage by the House is likely, the CHOICE Act is unlikely to pass the Senate because of its lack of any Democratic support.

However, OLA repeal, separate from the broader components of the CHOICE Act, could potentially be enacted through a different Congressional process known as reconciliation. OLA repeal is eligible for reconciliation because it is scored by CBO as reducing the deficit (despite the fact that in the long-run it is budget neutral). Hence, OLA is considered one of the more vulnerable portions of the Dodd-Frank Act.

The Trump Administration has initiated a review of OLA, issuing an Executive Order in April requiring the Treasury Secretary to “conduct a thorough review of OLA and provide a report to the President within 180 days.” This report will include an analysis of many of the arguments behind criticism of OLA, such as moral hazard and the ability of the bankruptcy code to handle the failure of a large, complex financial firm. The issuance of the report should provide further guidance as to what the Administration’s position and plans are. However, one potential sign of opposition to OLA was included, which is that the Secretary should not approve usage of OLA until after the study is complete. While it is highly unlikely that OLA would need to be triggered in the next six month, this statement from the President is a strong signal of skepticism.

Several former financial regulators of both parties, including former Federal Reserve Chairman Ben Bernanke and Paul Volcker, former FDIC Chair Sheila Bair, as well as numerous restructuring experts and legal scholars, such as Jim Millstein, David Skeel, and Rodgin Cohen have all recently written in support of retaining OLA. Several conservatives have embraced the CHOICE Act and continue to make the case to repeal OLA. The debate will continue and despite the broad initial support for the establishment of OLA, its future is uncertain.