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Reprinted with permission.
By Deborah Solomon - WSJ
WASHINGTON—Federal regulators proposed a rule that would require creditors of large financial firms to suffer losses in the event of a firm's collapse but left wiggle room for the U.S. to make payments to certain types of creditors.
The proposal is the first step in the government's effort to clarify how it will seize and dismantle large financial firms that run into trouble. The Federal Deposit Insurance Corp. was given authority to liquidate firms as part of the U.S. effort to prevent another collapse like that of Lehman Brothers, whose demise rippled through the financial sector.
The agency is expected to propose additional rules next year outlining how it would dismantle a large firm, including ways to recoup money from the financial industry in the event the U.S. has to step in and provide temporary funding.
The FDIC proposal comes as international regulators are grappling with the same issue of "too big to fail," seeking ways to prevent taxpayer bailouts across the globe and improve cross-border coordination in the event of a failure.
The Financial Stability Board, a group of regulators, central bankers and finance ministers, expects to present a series of proposals at the meeting of the Group of 20 industrial and developing nations in Korea next month. The proposals may include stricter capital standards for firms and requirements that they submit so-called "living wills," or plans for how they could be dismantled without harming the broader financial sector.
On Tuesday, the Federal Deposit Insurance Corp. took a first step by saying it planned to prohibit additional payments to shareholders and long-term debtholders in the event of a firm's demise. The FDIC said it could make additional payments to certain short-term creditors in situations where it maintains "essential operations" or to "minimize losses and maximize recoveries."
FDIC Chairman Sheila Bair said the authority to differentiate between creditors would be used rarely and would require approval of the entire FDIC board. She said such payments would most likely be confined to paying creditors for things like keeping the lights and computer systems up and running.
But the agency will have discretion to pay other types of creditors if the board determines such payments would "maximize recovery." For example, Ms. Bair said such payments could occur if a potential acquirer of a firm's assets said it would be willing to pay more if the FDIC didn't impose losses on a certain class of creditors.
The FDIC could also allow payments to counterparties holding short-term securities or other short-term creditors of a failing firm if the FDIC determines that would help prevent a disorderly collapse.
The proposal has been controversial, with some academics and officials in the Treasury Department worried that this discretion would encourage unprotected creditors to flee a faltering firm, accelerating its demise.
An FDIC official said any such payments could ultimately be reclaimed or subject to a "claw-back" by the government if the U.S. needed to recoup any taxpayer money spent on the liquidation. The FDIC also has the authority to levy a fee on the financial industry to recoup costs. An overarching goal of the financial overhaul, approved earlier this year, was to prevent taxpayer money from being spent on financial rescues.
The proposed rule, approved by the board last Friday, includes a request for public comment on a broader range of questions that the FDIC will use as it crafts its rules. The public has 90 days to comment on the questions and 30 days to comment on the proposed rule.