research - politico...jul 12, 2011 · standard & poor's ratings services believes that...

RESEARCH

Financial Institutions Research

The U.S. Government Says SupportFor Banks Will Be Different "NextTime"--But Will It?Primary Credit Analyst:Rodrigo Quintanilla, New York (1) 212-438-3090; [email protected]

Secondary Contacts:Matthew Albrecht, CFA, New York 212-438-1867; [email protected] Browne, New York (1) 212-438-7399; [email protected]

Table Of Contents

Legislation And Financial Crises—Moving To OLA

Banks May Need Extraordinary Government Support After All

The Three Categories Of Government Support

Why We May Rethink Our View Of Extraordinary Government Support

A "Wait-And-See" Mindset

Appendix: Review Of Legislative Initiatives

Related Criteria And Research

July 12, 2011

www.standardandpoors.com/ratingsdirect 1

878377 | 301101501

The U.S. Government Says Support For BanksWill Be Different "Next Time"--But Will It?The Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) passed on July 21, 2010, can be seen as

an attempt by the U.S. government to make clear that troubled financial institutions facing future financial stress

will not have the benefit of extraordinary government support. In fact, both legislators and regulators have

underscored this by prohibiting the government from taking an equity interest in any covered financial company or

subsidiary, or providing any other type of bespoke extraordinary support. It would seem "too big to fail" has ended.

But, has it really?

Standard & Poor's Ratings Services believes that the primary goal of DFA is to make banks less risky and better

capitalized so the need for extraordinary support is reduced. However, given the importance of confidence

sensitivity in the effective functioning of banks, we believe that under certain circumstances and with selected

systemically important financial institutions (SIFI), future extraordinary government support is still possible.

The U.S. government has a long track record of supporting the banking system (see Appendix). But the

government's authority to regulate and supervise hasn't always prevented bank failures or the need for selected

bailouts or tailored assistance. Time and time again, the U.S. government has found ways--many times

reluctantly--to contain systemic risk and limit economic fallout when large financial institutions are on the brink of

failure. The government has done this through outright new capital instruments (i.e., net-worth certificates),

open-bank assistance, and simple regulatory capital forbearance.

Overview

• Standard & Poor's Ratings Services believes that the primary goal of DFA is to make banks less risky and better capitalized so the

need for extraordinary support is reduced.

• We believe that under certain circumstances and with selected systemically important financial institutions, future extraordinary

government support is still possible.

• We believe that amendments to the current legislation or outright changes in a future crisis might prove necessary, especially

when the government faces circumstances that could depress the real economy and threaten the well-being of its citizens.

Whether the U.S. government will remain "supportive" of its banking industry has come into question as a result of

constraints that Title II (Orderly Liquidation Authority or OLA) of DFA imposes. "Supportive" here focuses on

extraordinary government support, not just ongoing system support (see External Support Key In Rating Private

Sector Banks Worldwide , published Feb. 27, 2007, on RatingsDirect on the Global Credit Portal). DFA attempts to

create a comprehensive and robust regulatory framework and, in our opinion, effective implementation may provide

a good theoretical blueprint to promote financial stability and reduce systemic risk. However, this legislation, in our

view, has not addressed the demand side of risk, risk-mitigation efforts, or the fact that a two-tier regulatory system

will likely continue to move risks into the loosely regulated shadow-banking system.

Title II may not be enough either to prevent systemic failures or to address the orderly resolution of a SIFI as

legislators and regulators have hoped. The fragility of market confidence came to the fore in the most recent crisis.

Standard & Poor’s | RatingsDirect on the Global Credit Portal | July 12, 2011 2

878377 | 301101501

We believe regulators can create prudential standards to promote market stability. But it is difficult to create

legislation that ensures market confidence at all times despite a regulator's attempt to promote it, such as through

the increase in deposit insurance coverage to $250,000. We believe that implementation of OLA could increase

uncertainty in the market at a time when confidence needs boosting. For instance, dismantling a large financial firm

might spur creditors to pull out of other similar financial firms in times of stress. Creditors may react by cutting off

funding sooner and accelerating the failure process. One lesson from the recent crisis is that fund providers' loss of

confidence can very quickly trigger liquidity events, which can lead to a firm's failure. So although DFA constrains

the type and form of support that the government can give (i.e., the financial firm has to be in liquidation), we

believe that amendments to the current legislation or outright changes in a future crisis might prove necessary,

especially when the government faces circumstances that could depress the real economy and threaten the well-being

of its citizens.

Legislation And Financial Crises—Moving To OLA

In response to outsize financial crises that have involved numerous or large banks, legislators and regulators usually

have responded with changes--some significant--to banking legislation and regulation. They cite the need to avoid a

repeat of past mistakes and ensure that financial institutions are strong enough to weather the next crisis. To be

sure, the regulatory reform of the 1930s worked relatively well for 50 years, with only 584 bank failures--about

3%-4% of the total average number of commercial banks during that entire period. The situation changed sharply

in the 1980s, and legislators and bank regulators deregulated interest rates to increase the effectiveness of monetary

policy in a high-inflation environment. The Monetary Control Act of 1980 and Garn-St. Germain in 1982 were the

centerpieces of this deregulation. The freeing of bank interest rates, however, led to large losses in the financial

sector. For instance, there were more than 1,800 failures and Federal Deposit Insurance Corp. (FDIC)-assisted

transactions (or an average 13% of all FDIC-insured institutions) from 1983 to 1989. In fact, the FDIC has argued

that those acts increased the direct cost of resolving the savings-and-loan crisis, which the Government

Accountability Office estimates at about $160 billion, or roughly 2% of gross domestic production in 1995 when

Congress terminated the Resolution Trust Corp. Likewise, FIRREA in 1989 and FDICIA in 1991 failed to prevent

the savings-and-loan or banking crises, and were more reactive in nature. More recently, the FDIC has reported

about 370 failures and assisted transactions since 2008, or about 4% of the total number of banks and thrifts. The

loss to the deposit insurance fund was $57 billion in 2009 alone, according to the FDIC, but this does not reflect the

full cost of the support provided.

A sharp economic downturn accompanied by extremely high losses and a loss of confidence in the banking sector

can amplify a downturn. Because currency and demand-deposit liabilities of banks constitute the means of payment

in the economy, governments have been particularly interested in maintaining depositors' belief that they can

withdraw their money at par at any time. As deposit-taking financial institutions and their bank holding companies

have become more complex or diverse, and as they have had to compete with other sectors of the financial industry,

they have had to rely more on market funding. This funding can flee or stop if confidence in repayment erodes,

unless the market believes the bank is too big to fail (e.g., its size will impel governmental authorities to keep it

functioning through extraordinary funding or guarantees).

Much is at stake when large and strongly interconnected financial institutions fail in a disorderly fashion. Title II of

DFA provides a blueprint for the orderly resolution of large and systemically important bank holding companies

and nonbanks (as "covered companies") by the FDIC and establishes the Financial Stability Oversight Council


878377 | 301101501

The U.S. Government Says Support For Banks Will Be Different "Next Time"--But Will It?

(FSOC) to identify these covered companies. In particular, Title II provides the framework for what banking

regulators can or cannot do for the orderly resolution of failing SIFIs in liquidation. In theory, an orderly liquidation

would limit the contagion inherent in a large, globally interconnected financial institution's failure. The U.S.,

however, is not alone in seeking to limit government support for banks. Globally, much attention has focused on the

adoption of regulatory frameworks and resolution regimes that eliminate or at least sharply reduce the moral hazard

of too big to fail (see Bank Resolution Regimes: Potential Rating Implications As Sovereign Support Frameworks

Evolve , published March 16, 2011, on RatingsDirect on the Global Credit Portal).

The FDIC already has broad powers to resolve an insured depository institution in a manner that minimizes

disruption to the banking system and maximizes value. In addition, DFA through OLA allows the FDIC to create

one or more bridge banks, enforce cross-guarantees among sister banks, sell and liquidate assets, and settle claims.

The OLA can apply to bank holding companies, broker/dealers, insurance companies, or any other financial

company under the supervision of the Federal Reserve if the Secretary of the Treasury, the Fed, and other

firm-specific regulators vote to agree. Those voting must consider, among other things:

• Whether the company is in default or near default;

• The effect that default might have on financial stability in the U.S.;

• If there is a private-sector alternative to default;

• Why the bankruptcy code might not be appropriate; and

• What effect default would have on shareholders, creditors, counterparties, etc.

The Secretary of the Treasury then takes action if, among other considerations:

• The failure of the company and its resolution under otherwise applicable laws would hurt financial stability in the

U.S.;

• No viable private-sector alternative exists;

• The impact on shareholders, creditors, and counterparties is appropriate given that action; and

• Federal regulators have already ordered the conversion of all convertible debt instruments.

The key to the FDIC's authority as receiver of a covered financial company is its ability to:

• Conduct advance resolution planning for SIFIs;

• Provide immediate liquidity for an orderly liquidation;

• Make advances and prompt distributions to creditors based upon expected recoveries;

• Create bridge financial companies to continue systemically important operations; and

• Transfer all qualified financial contracts with a given counterparty to another entity and avoid their immediate

termination and liquidation.

In an orderly liquidation, Title II mandates that creditors and shareholders share in losses if claims exceed the value

of assets, that top management and other responsible parties not be retained, and that creditors bear losses including

financial damages and recoupment of compensation. To those ends, DFA specifies that the FDIC should ensure that

shareholders do not receive payment until the bank pays all other claims, and that unsecured creditors bear losses in

accordance with the priority of claims provisions. The FDIC is also prohibited from taking an equity interest in any

covered financial company or subsidiary.


878377 | 301101501


Banks May Need Extraordinary Government Support After All

Bank regulators are working toward meeting DFA's rule-making deadlines. But some general implementation details

are still unclear or undetermined. Notwithstanding, we believe that the OLA powers that DFA gives to regulators

will not by themselves prevent future government support of a handful of individual financial institutions. From our

perspective there are several reasons why regulators will likely face obstacles in executing an orderly resolution of

failing banks and ensuring that confidence in financial markets does not erode during periods of stress.

Franchise stability and market confidence are critical

Our fundamental criteria on assessment of liquidity focus on the stability of funding sources, where core retail

deposits are preferable to wholesale sources of funds, particularly if they are short term. Although most financial

institutions are vulnerable to a loss of confidence (because they typically fund most of their assets with debt), some

wholesale banks and nonbank financial companies are more vulnerable than others depending on their business

models and funding mix. For instance, specialist lenders that depend on short-term wholesale funding and financial

institutions with large trading operations are particularly sensitive to an erosion of confidence. For all banking

institutions, the worst-case result of an erosion of confidence is a significant outflow of wholesale or retail customer

deposits (a bank run).

We believe that financial institutions most exposed to volatile markets and loss of investor and counterparty

confidence will likely continue to be vulnerable to loss of market access. Consequently, "sudden default" risk will

likely remain a characteristic of large and complex financial institutions, although the significant measures that

governments around the world have taken to shore up funding and liquidity requirements should reduce this risk

somewhat.

Large financial firms are structurally complex

Many large institutions are functionally organized around lines of business to improve efficiency, to manage risk

effectively, to support product capabilities, to provide access for customers, to minimize tax liabilities, and to hedge

against regulation, among other reasons. The functional structure, however, will not necessarily match the legal

structure. As a result, a given function or business may operate in many separately incorporated lines of business

from a multitude of jurisdictions. The resulting structural complexity can make resolution planning and execution

more difficult.

Cross-border operations will be subject to different jurisdictional regimes and timelines

DFA does not consider wind-down situations following a group methodology--that is, dealing with foreign

subsidiaries of U.S. financial institutions or troubled subsidiaries of foreign firms operating in the U.S. Legislators

assumed that foreign regulators would cooperate with U.S. banking regulators in such matters. In addition, as

institutions identify gaps and impediments, some remediation efforts may take longer to plan and implement.

International regulators may not act in coordination with the FDIC, making deployment of an effective global

resolution plan difficult.

Effective execution of living wills and long-term resolution planning

DFA requires that covered financial institutions submit a resolution plan for their orderly liquidation by the FDIC if

they become insolvent (a "living will"). However, we believe that these plans ought to be integrated with long-term

strategic planning into the larger risk framework of the organization because the information requirements are

different from those needed on a day-to-day basis. Moreover, plans need to be flexible because the actual insolvency


878377 | 301101501


situation may be very different from the planned-for scenario. Moreover, creating a living will that will be useful in

an unforeseeable crisis is inherently difficult. Lastly, putting reasonable and workable living wills in place may take

years. From our perspective, the most-recent financial crisis is not completely over. Therefore a SIFI without a

workable living will could get in trouble in the near term.

Management issues

It will be important to identify the appropriate people to advance the enterprise and execute the wind-down process.

Covered companies by definition will be large and complex--quite different from the type of banks the FDIC has a

history of receiving and resolving. Retaining critical managers and motivating them to work in the wind-down of

business may be key to the overall success of the orderly resolution.

Enhanced macroprudential capital standards may not be enough to contain the loss of confidence

Bank regulators intend to increase minimum regulatory capital standards and include an extra buffer for

systemically important financial firms. Details and specifics are still under discussion, although the Basel committee

has announced a 1.0%-2.5% capital buffer for SIFIs. However, it could apply an incremental 1% add-on for firms

at the top end of the range to discourage the largest banks from becoming significantly bigger. Undoubtedly, more

capital (especially common equity) is better than less. But the banks that failed, were provided extraordinary

assistance, or were acquired just before failure presented high regulatory capital ratios (see table 1). Thus, high

regulatory capital ratios in and of themselves may not be enough to preempt a "run on the bank" as regulators

expect, which reveals some limitations of a rule-based system. The market may start recognizing lifetime losses of

risky assets all at once, as happened in the fall of 2008. Because unrealized losses that made banks appear stronger

than they otherwise would have were not considered in regulatory tier 1 capital during the crisis, the market put

more value in tangible common equity ratios.

Table 1

Regulatory Capital Ratios For Selected Banks Prior To Failure, Extraordinary Government Assistance, Or Acquisition

Last reporting quarter Tier 1 capital ratio (%) Total capital ratio (%)Tangible capital ratio

(%)

Whitney Holding Corp. March-11 11.87 14.91 9.91

National City Corp. September-08 11.00 14.89 8.93

Downey Financial Corp. September-08 13.17 14.50 7.48

Marshall & Ilsley Corp. March-11 10.95 14.13 11.24

Washington Mutual Inc. June-08 7.76 13.93 7.79

Countrywide Financial Corp. September-08 11.10 12.40 6.90

Wachovia Corp. September-08 7.49 12.40 4.02

Wilmington Trust Corp. December-10 7.51 12.29 4.59

Chevy Chase Bank FSB June-08 9.29 12.24 5.30

Regions Financial Corp. September-08 7.47 11.70 5.69

Citigroup Inc. September-08 8.19 11.68 3.52

Colonial BancGroup Inc. March-09 7.33 11.56 3.21

Bank of America Corp. September-08 7.55 11.54 4.02

Indymac Bancorp March-08 9.00 10.26 5.74

The South Financial Group Inc. June-10 8.52 10.24 5.21

AmTrust Bank September-09 4.15 5.44 2.41


878377 | 301101501


Table 1

Regulatory Capital Ratios For Selected Banks Prior To Failure, Extraordinary Government Assistance, Or Acquisition(cont.)

*Companies are listed by their holding-company name but include bank-level regulatory capital ratios for the thrifts. Countrywide's thrift didn't constitute a majority of its

assets and most of Countrywide's problems were outside its thrift. Indymac's OTS regulator allowed the holding company to make a back-dated equity investment into the

thrift. If not for this, Indymac would have been under the "well-capitalized" standard. Source: Standard & Poor's Financial Institutions Research; FFIEC.

The FDIC attempted to address questions about how it would have resolved the Lehman Brothers failure under

OLA. We agree the transfer of qualified financial contracts (including swaps, repos, securities contracts, commodity

contracts, and similar agreements) to a bridge or acquiring company under OLA should help mitigate the

market-wide disruption a large-scale bankruptcy might cause. But some issues remain unresolved: Would the FSOC

have identified Lehman as a SIFI? Would there have been enough financial information about emerging risks to

classify it accurately as such and resolve it? Would its "living will" have been reasonable for a wind-down? Would

the FSOC have assessed the potential global impact properly? Would bank regulators abroad have cooperated with

the FDIC in its resolution? New products and markets develop rapidly, and the risks inherent in those new products

often become apparent only through a crisis. Faith in the OLA relies on the belief that risks can be identified early

and mitigation can be planned.

The Three Categories Of Government Support

Extraordinary support became most evident in the U.S. on Oct. 14, 2008, when the government, through a joint

statement by the Federal Reserve Board, the Treasury, and the FDIC, announced three actions following the

enactment of the Emergency Economic Stabilization Act of 2008. These included a voluntary capital purchase

program (CPP) whereby U.S. financial institutions would sell preferred shares to the government; the Temporary

Liquidity Guarantee Program, which allowed the FDIC temporarily to guarantee the senior debt of all FDIC-insured

institutions and certain holding companies; and the Fed's Commercial Paper Funding Facility program to fund

purchases of high-quality issuers' three-month commercial paper. Initially, nine financial institutions signed up for

the CPP and to have the FDIC guarantee their debt. At that time, authorities also identified these nine institutions as

systemically important, implying that the breadth and scope of their operations and exposures were such that

non-support would likely destabilize the global financial system. In our view, these actions helped stabilize the

financial system and restore market confidence.

We currently classify governments into three categories: interventionist, supportive, and support uncertain.

Interventionist

Interventionist governments tend to make support for systemically important banks explicit on an ongoing basis,

demonstrate this frequently through government actions, and are likely to continue such policies. Tangible forms of

support can include subsidies, financial injections, and ownership links. Examples include Japanese authorities'

support of systemically important banks through the stresses that began in the 1990s.

Supportive

Supportive governments rely on prudential policies--including mechanisms to support failing banks--to maintain a

sound banking sector. They are likely to provide more-explicit individual targeted support systemically important

banks in a crisis. The nature of this support is likely to depend on the health of the bank, and would become more

explicit and targeted in response to a particular problem at a bank.


878377 | 301101501


When banks are performing well in such countries, the authorities rarely have a need or incentive to provide direct

financial support. The governments in these countries, however, promote the soundness of their banking systems

through prudential standards, reinforcement of the legal infrastructure, and robust liquidity mechanisms.

Some banks will receive significant direct support from the authorities in the event of a problem, but the authorities

may decide not to provide direct support to another bank, instead coordinating the provision of support by other

market participants (such as the purchase by another entity). Other banks may be allowed to fail or to proceed to a

relatively orderly wind-up, particularly if a market-based solution is not successful.

Such governments are likely to base the decision to support a bank on a cost-benefit consideration of the economic

and social implications of the bank's failure versus the cost to the taxpayers of a bailout. In some circumstances, the

authorities may face financial or legal constraints affecting the type of support that they can provide. The nature and

timing of the support a supportive country would provide may differ depending on the profile of the bank and the

cause of the bank's problem. Various classes of creditors may receive different levels of support. Because many of

these countries are increasingly oriented toward market-based solutions, the government or regulators may guide or

direct other banks toward a takeover of the troubled bank. In other situations, the support could come in direct

financial form, or through some type of regulatory forbearance.

Support uncertain

A support uncertain government may support banks, but its policy is unpredictable, either because of a weak

institutional infrastructure or reliance on market solutions or bank owners. Governments in this category may

intervene when major private-sector banks are failing, but they are more likely to let events run their course, allow a

private-sector solution, or let bank owners support failing banks. Countries in this category may have undeveloped

or unpredictable bank regulation and relatively weak political institutions.

The more a country's bank regulation advances toward best practices, the more likely it will be in the "supportive"

rather than "support uncertain" category, even if its economic policies are market oriented. In countries classified as

"support uncertain," it is very difficult to predict the responses of the national authorities to a stress at a

systemically important bank. We do not incorporate the potential for external support into our bank ratings until

we are certain of the government response. When there is sufficient clarity about the government actions, then the

ratings will incorporate the benefits.

We may not consider governmental support in rating junior securities to the same extent as we consider it in

counterparty and senior debt ratings, if at all. Ratings on instruments like preferred stock and hybrid equity on

which payment may be deferred, for example, may be substantially lower than the issuer or senior debt ratings if we

feel government support would not prevent payment default on the junior instruments.

Why We May Rethink Our View Of Extraordinary Government Support

We classify the U.S. as supportive, because despite its general belief in the market's dominant role in economic

policy, it maintains extensive regulation that empowers banking regulators and emphasizes proactive measures to

identify and cure problems at the onset. Under our proposed new bank criteria (see Request for Comment: Banks:

Rating Methodology, published Jan. 6, 2011, on RatingsDirect), among the characteristics that we would look for

to change the classification to support uncertain are an unambiguous policy or legislation preventing direct support

to financial institutions under any condition or an explicitly mandated loss-sharing of senior unsecured creditors on


878377 | 301101501


losses related to a bank failure.

Under current criteria, our approach to reflect potential extraordinary future external support in bank credit ratings

treats the interventionist category differently from the supportive and support uncertain categories. The credit

ratings on systemically important private-sector banks in interventionist countries receive an explicit uplift over the

stand-alone ratings (which exclude extraordinary external support). This uplift typically is one notch, although it

can reach three notches or more in cases of troubled private-sector banks. Under our proposed new bank criteria

(see Request for Comment: Banks: Rating Methodology, published Jan. 6, 2011, on RatingsDirect), we propose

recognizing government support throughout the cycle and not just during a crisis when we consider government

support to be sufficiently high. The extraordinary government support we expect a bank to receive is by no means

certain. This uncertainty means that the support uplift will never result in equal ratings on a nongovernment-related

bank and the sovereign.

Under both existing and proposed criteria, we regard the likelihood of government support for private-sector

commercial banks as a function of both the bank's importance in maintaining overall confidence in the financial

system (or what we call systemic importance) and the government's tendency to support private-sector commercial

banks. We regard private-sector commercial banks as having high, moderate, or low systemic importance. We then

combine these two factors to derive the likelihood of direct government support in the future for private-sector

commercial banks (see How Systemic Importance Plays A Significant Role In Bank Ratings , published July 3, 2007,

on RatingsDirect).

We rate banks with a direct link to government ownership or policy banks that may have a claim to the government

under our government-related entities (GRE) criteria (see Rating Government-Related Entities: Methodology and

Assumptions , published Dec. 9, 2010, on RatingsDirect). We apply a closely related methodology in rating banks

that the government directly owns or controls, and policy institutions such as export credit banks. We treat state

banks, policy financial institutions, and state enterprises in other economic sectors as GREs, reflecting their closeness

to the government and the strong likelihood that the government will take direct actions that will affect their

creditworthiness. We also categorize systemically important private-sector banks in interventionist countries as

GREs.

A "Wait-And-See" Mindset

In the words of Fed Chairman Ben Bernanke during his testimony before the Financial Crisis Inquiry Commission

on Sept. 2, 2010, "A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are

such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would

face severe adverse consequences."

We expect the pattern of banking-sector boom and bust and government support to repeat itself in some fashion,

regardless of governments' recent and emerging policy response. Governments support their national economies and

financial systems and this support often results in added protection for senior creditors of systemically important

commercial banks, but the link is by no means certain. Confidence is important in banking because institutions

borrow short and lend long. Their risk appetite and shareholder-return goals compound the issue.

The U.S. government indeed has a long track record of supporting its large and systemically important financial

institutions despite its stated preference for not doing so. DFA may limit this activity, but we believe the government


878377 | 301101501


may try to avoid contagion and a domino effect if a SIFI finds itself in a financially weakened position in a future

crisis. The rules and regulations resulting from DFA and Title II could be amended or changed. After all, with a loss

in confidence similar to the situation in 2008, the government will be motivated to ward off the market's question:

"Who is next?" Ultimately, in our views of new legislation and regulation, we need to consider the long track-record

of extraordinary support that may be essential for a handful of institutions despite government reluctance to offer

such support.

The U.S. banking system is more concentrated today than it was before the crisis. To illustrate, the top five

commercial banks now hold half the banking system's assets, compared with 45% at the end of 2005. Banks with

more than $50 billion in assets comprise 75% of the system's assets, and thus we think it would be impractical to

consider all of them SIFIs given this low threshold. Higher deposit-insurance coverage may translate to greater

sovereign exposure, even as systemic risk may be reduced by providing a higher comfort level to depositors.

Moreover, a two-tier regulatory system likely will continue, shifting emerging risks to the loosely regulated

shadow-banking system as in the past. With lower returns expected from a more highly capitalized banking system,

the search for risk will likely shift toward the shadow-banking system.

Lastly, in an effort to reduce banks' risk, exchanges and clearinghouses will assume more risk under DFA (see Credit

FAQ: Are Exchanges And Clearinghouses 'Too Big To Fail'? , published Nov. 11, 2010, on RatingsDirect). In the

end, banking regulators will have fewer tools to deal effectively with troubled financial institutions.

There has been much discussion about the true implications of DFA and whether it has, in fact, eliminated "too big

to fail." The market perception indicates the whole spectrum of outcomes, from complete certainty of bond default

for a SIFI to a "maybe under certain conditions" outcome, in which senior bondholders may not bear any losses.

Finalization of certain rules and regulations and future amendments to DFA could alter our view of whether the U.S.

remains "supportive." But, for now, we agree with Alan Greenspan's statement before the Council on Foreign

Relations in New York City on Oct. 15, 2009: "If they're too big to fail, they're too big."

Appendix: Review Of Legislative Initiatives

In numerous instances, U.S. banking regulators have stepped up regulation and supervision to ensure the financial

system remained safe and sound when faced with potentially hurtful systemic losses.

The Banking Act of 1933

Congress passed the Banking Act of 1933 (Glass-Steagall) after several thousand banks failed in the early 1930s. The

act established the FDIC and federal deposit insurance and prohibited banks from engaging in certain investment

activities. It also implemented Regulation Q, which prohibited payment of interest on demand deposits and

authorized the Federal Reserve to set interest-rate ceilings on time and savings deposits paid by commercial banks.

Regulation Q, in part, was meant to discourage smaller banks from holding deposits at large banks--limiting

systemic risk from interbank liabilities. It also was an effort to protect bank profits by limiting funding costs,

thereby reducing the incentive for banks to take excessive risk.

The Bank Holding Company Act of 1956

Together with its amendments from 1970, Congress sought to limit nonbanking activities of commercial banks. The

motivation was to reduce the risks to which banks might be exposed. The widespread belief was that if banks

expanded into new and risky areas, they would introduce idiosyncratic risk that would affect the soundness of the


878377 | 301101501


banking system.

The Monetary Control Act of 1980

Regulation Q was problematic for banks and thrifts in the late 1970s when market interest rates rose above the

ceiling rates on deposits. That resulted in a large outflow of deposits into money-market mutual funds, causing

liquidity problems for banks and thrifts. Congress reacted by passing the Depository Institutions Deregulation and

Monetary Control Act in 1980. Among other things, the act phased out the Fed's power to set interest-rate ceilings

on time and savings accounts of more than six years, allowed thrifts to offer checking accounts, and raised deposit

insurance to $100,000 from $40,000.

The Garn-St Germain Depository Institutions Act of 1982

Despite the Monetary Control Act of 1980, some banks and thrifts called the phase-out of deposit-rate ceilings too

slow and continued to lose deposits to money-market mutual funds. Also, several banks failed in 1981 and 1982

amid a weak economy and as high interest rates made it difficult to manage interest-rate risk. Most notably,

Oklahoma-based Penn Square Bank failed in 1982. At the time, this was the largest bank failure in U.S. history in

which uninsured depositors suffered losses. The FDIC opted to liquidate Penn Square instead of selling it to another

institution or supporting it through "open-bank assistance" (allowing the bank to continue operating with some

restructuring or help from the FDIC). The latter two options would likely have protected uninsured depositors, but

the FDIC did not believe either was feasible. For instance, legislation mandated that the FDIC could only provide

open-bank assistance to institutions deemed "essential" to their communities, which Penn Square was not.

Following Penn Square's failure, Congress passed the Garn-St Germain Depository Institutions Act. It allowed banks

and thrifts to offer money-market deposit accounts to help offset the loss of funding to money-market mutual funds.

It also gave the FDIC greater authority to provide open-bank assistance and made it easier to conduct interstate

acquisitions of large failed banks and thrifts. The act established "net worth certificates," allowing the FDIC to

inject capital into thrifts by purchasing these certificates, effectively allowing them to continue operating with weak

quality capital.

The FDIC provided open-bank assistance to 129 institutions and purchased net-worth certificates from 111 of them

from 1982 to 1992. Most famously, Continental Illinois National Bank and Trust Co., a $40 billion bank, received

open-bank assistance in 1984. Continental's problems surfaced with the failure of Penn Square Bank. No creditor or

depositor initially suffered any losses in the case of Continental Illinois, and shareholders even retained some

ownership. Later, however, shareholders were wiped out. The acrimonious debate that followed the bailout of

Continental Illinois led to the concept of "too big to fail," and paved the way for creditors' expectation that they

could count on the government to protect their interests in such failures. Faced with a growing number of troubled

banks in energy-dependent states and defaults on construction and development loans in overbuilt real estate

markets, the Fed and the FDIC practiced regulatory forbearance by holding back on enforcing capital adequacy

rules that would have forced otherwise failed banks to close.

At the same time, regulators hoped that troubled savings-and-loan companies would return to profitability given

enough time. To prop them up, they devised Regulatory Accounting Principles to create the appearance of sufficient

capital where there was too little or no true capital.

Competitive Equality Banking Act of 1987 (CEBA)

As the savings-and-loan crisis of the 1980s intensified, Congress passed CEBA to recapitalize the deposit insurance

fund for thrifts and to facilitate acquisitions of troubled institutions. It also allowed the FDIC to create "bridge


878377 | 301101501


banks," or temporary national banks, for up to three years. The act extended the net-worth certificate program for

thrifts for five years, and allowed small agricultural banks to amortize some loan losses.

The Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA)

FIRREA aimed to improve regulation and buttress the financial system amid the savings and loan crisis by:

• Creating two government-owned asset-management funds, including the Resolution Trust Corp., to liquidate the

assets of failed institutions;

• Creating a new thrift regulator, the Office of Thrift Supervision, and imposing stricter standards on thrifts'

capital, brokered deposits, and holdings of high-yield bonds;

• Mandating that the level of the Bank Insurance Fund (which replaced the Deposit Insurance Fund) had to be

increased until it reached 1.25% of insured deposits (and would not exceed 1.5%); and

• Expanding regulators' enforcement authority to suspend deposit insurance coverage, issue cease and desist orders,

and impose civil money penalties.

The Federal Deposit Insurance Corp. Improvement Act of 1991 (FDICIA)

Following FIRREA, the pace of bank and thrift failures remained high and the bank insurance fund needed to be

replenished. The U.S. government looked to measures to facilitate the resolution of the savings-and-loan crisis and to

prevent future crises. FDICIA prohibits federal agencies from forbearing in the closure of a failing institution by

declaring it "too big to fail" unless there was consensus among the FDIC, the Fed, and the Treasury that a large

institution's failure posed systemic risk. In addition, this Act:

• Increased the FDIC's authority to borrow from the U.S. Treasury to $30 billion from $5 billion;

• Established prompt corrective action (PCA) and five categories of capitalization from "well capitalized" to

"critically undercapitalized";

• Required regulators to conduct annual safety-and-soundness exams of all insured institutions;

• Required institutions with more than $150 million in assets to provide regulators with independently audited

annual financial statements;

• Prohibited undercapitalized banks from accepting brokered deposits; and

• Required risk-based deposit insurance assessments to be in place by 1994.

Directly in regard to banks considered too big to fail, FDICIA:

• Required the FDIC to use the least-cost alternative in resolutions unless the boards of the FDIC and the Federal

Reserve and the secretary of the Treasury believed a failure constituted systemic risk;

• Limited the ability of undercapitalized banks to borrow from the Fed's discount window and required the Fed to

impose limits on interbank liabilities; and

• Gave creditors at failed institutions immediate access to the funds they were entitled to at the time of failure.

The FDIC Board of Directors approved PCA on Sept. 15, 1992. Under PCA, regulators required an institution be

closed if it was "critically undercapitalized" (with a tangible equity-to-total assets ratio of 2% or less) and did not

have an adequate capital restoration plan.

Table 2

Key Legislative Initiatives In The U.S.

Date Legislation Description

1913 Federal Reserve Act Created central bank


878377 | 301101501


Table 2

Key Legislative Initiatives In The U.S. (cont.)

1933 Banking Act (Glass-Steagall) Introduced federal deposit insurance, segregated commercial and investmentbanking

1933 Securities Act Improved disclosure, required that securities sold across state borders be registeredwith the federal government

1934 Securities Exchange Act Created the Securities and Exchange Commission

1940 Investment Company Act Created a body to safeguard investor accounts and establish financial-responsibilityrules at securities firms

1956 Bank Holding Company Act Limited nonbank business activities

1970 Securities Investor Protection Act Created CFTC to regulate futures markets

1974 Commodity Futures Trading Commission Act Created CFTC to regulate futures markets

1980 Depository Institutions Deregulation and MonetaryControl Act

Deregulated savings-account interest rates, enforced minimum capital requirementsfor banks

1994 Interstate Banking and Branching Efficiency Act Allowed nationwide banking

1999 Financial Services Modernization Act(Gramm-Leach-Bliley)

Repealed Glass-Steagall, allowing commercial banks, investment banks, and insurersto merge

2000 Commodity Futures Modernization Act Exempted OTC derivatives from government oversight

2002 Public Company Accounting Reform and InvestorProtection Act (Sarvanes-Oxley)

Passed in response to Enron’s bankruptcy, overhauled corporate governance,strengthening role of auditors in overseeing accounting procedures

Source: The Economist and Standard & Poor’s.

Related Criteria And Research

• Bank Resolution Regimes: Potential Rating Implications As Sovereign Support Frameworks Evolve, March 16,

2011

• Request for Comment: Banks: Rating Methodology, Jan. 6, 2011

• Rating Government-Related Entities: Methodology and Assumptions, Dec. 9, 2010

• How Systemic Importance Plays A Significant Role In Bank Ratings, July 3, 2007

• External Support Key In Rating Private Sector Banks Worldwide, Feb. 27, 2007


878377 | 301101501


S&P may receive compensation for its ratings and certain credit-related analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the rightto disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), andwww.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-partyredistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result,certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain theconfidentiality of certain non-public information received in connection with each analytical process.

Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact orrecommendations to purchase, hold, or sell any securities or to make any investment decisions. S&P assumes no obligation to update the Content following publication in anyform or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/orclients when making investment and other business decisions. S&P's opinions and analyses do not address the suitability of any security. S&P does not act as a fiduciary oran investment advisor. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence orindependent verification of any information it receives.

No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified,reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P. The Contentshall not be used for any unlawful or unauthorized purposes. S&P, its affiliates, and any third-party providers, as well as their directors, officers, shareholders, employees oragents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors oromissions, regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content isprovided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OFMERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONINGWILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to anyparty for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, withoutlimitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages.

Copyright © 2011 by Standard & Poors Financial Services LLC (S&P), a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.


878377 | 301101501

research - politico...jul 12, 2011 · standard & poor's ratings services believes that...

Documents