Turning to the second main theme I would like to discuss, resolution is being offered up by some as not only a necessary element of the solution to the too big to fail problem (a proposition I agree with), but also as an entirely sufficient solution that eliminates the need for heightened prudential standards to reduce the probability of failure in the first place. The argument is based on the view that, in resolution, shareholders’ equity will be wiped out and that some portion of the long-term debt will be converted to equity. The prospect of this outcome will, it is argued, lead to a disciplining effect by the parent company’s long-term debt holders, who will demand higher yields now that the prospect of failure is credible. This, in turn, will help to eliminate the implicit subsidy of too big to fail. Under this theory, Title II would also limit the incentives for firms to become larger and more complex in order to gain this funding subsidy. By itself, however, Title II does not entirely eliminate the advantages of being large and complex. That is because large, complex firms are more likely to go through Title II than smaller, less complex bank holding companies, who will generally go through a Chapter 11 bankruptcy proceeding. Also, only large firms will benefit from Title II’s one-day stay on qualified financial contracts.
One of the key pillars of Title II is that, unlike a bankruptcy proceeding, the FDIC will have access to liquidity from the U.S. Treasury to help ensure an effective resolution. While this access provides significant support for an effective resolution, it will still be important for the resolution authorities to provide clarity about the timing and the amount of liquidity resources that will be made available after a firm enters into resolution. This clarity will likely be necessary in order to calm creditors and markets at the time of resolution. Under the single point of entry framework, the intent is to create a highly capitalized bridge entity so that counterparties will be willing to stay engaged based upon the improved creditworthiness of the bridge parent and its recapitalized subsidiaries. If successful, this will reduce the need for the up-front provision of external liquidity resources. Nevertheless, to make the viability of the bridge entity fully credible, market participants must believe that the bridge company has access in a timely way to whatever additional liquidity resources might prove necessary. In addition, under the Dodd-Frank Act, Title II is not the baseline or preferred approach for dealing with the failure of a large complex firm. For a firm to go through Title II, a determination must first be made that the failure of the firm and its resolution would have serious adverse effects on U.S. financial stability under the insolvency law that would otherwise apply.