Treasury calls for new bankruptcy code to avert federal backstop for failing banks

The Treasury Department on Wednesday called for preserving a limited form of a federal fund meant to protect the U.S. economy from bank failures, a policy long targeted by conservatives.

In a report released Wednesday, the Treasury said that the Dodd-Frank Act’s orderly liquidation authority (OLA) has serious flaws and should only be used in extreme conditions.

The department called on Congress to expand the federal bankruptcy code to include a better process for failing banks to dissolve without sparking a credit freeze.

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“Our recommendations begin with a proposal to narrow the path to OLA by building a more robust, effective bankruptcy process for financial companies,” Treasury wrote in the report.

The report takes aim at a key provision of the Dodd-Frank rules passed after the 2008 financial crisis meant to prevent a similar crash from happening again. 

Dodd-Frank empowers the Federal Deposit Insurance Corporation (FDIC) to take over the assets of failing banks or financial firms that could trigger widespread financial turmoil upon collapse. Dodd-Frank’s OLA gives FDIC access to a fund financed by fees on banks and major financial firms that would give the agency enough resources to disassemble the bank.

Democrats and Dodd-Frank’s supporters say OLA is a critical tool that prevents the need for the federal government to bail out failing banks. They argue that since the fund doesn’t use taxpayer money, it helps protect Americans from exposure to risks in the financial markets.

Critics of the law, including Republicans, have long argued that the OLA incentivizes risky behavior at big banks with a government guarantee they consider a bailout, despite the lack of taxpayer funding. House conservatives made replacing OLA with a new bankruptcy process for banks a centerpiece of their efforts to dismantle Dodd-Frank, but it hasn’t seen action in the Senate.

Treasury agreed with conservative criticisms of OLA, but proposed a more moderate path in line with the financial industry’s post-crisis consensus.

“We conclude unequivocally that bankruptcy should be the resolution method of first resort. Our reason is simple: market discipline is the surest check on excessive risk-taking, and the bankruptcy process reinforces market discipline through a rules-based, predictable, judicially administered allocation of losses from a firm’s failure,” Treasury wrote.

Treasury has proposed adding a new, 14th chapter to the bankruptcy code. The “Chapter 14” policy would allow a failing bank or financial firm to petition a court for approval to transfer its assets to a bridge company within 48 hours. That bridge company would also take on the ownership assets of the financial company’s subsidiaries, a move meant to prevent the company from self-immolating.

Chapter 14 would include a stay on termination rights of parties who are involved in derivatives contracts with the failing firm, and the financial liability would rest with the company’s shareholders, management and certain creditors.

“The statutory standard for invoking OLA is already exceedingly high. But the adoption of a Chapter 14 bankruptcy process will further guarantee that OLA is truly the option of last resort,” Treasury wrote.

Treasury recommended ending FDIC’s ability to prioritize the claims of certain creditors within the same class, requiring a bankruptcy court to decide how the company’s assets will be distributed and limiting the time and extent that OLA fund money is extended to the bridge company.

Banks largely praised the Treasury report for preserving OLA, one of the few parts of Dodd-Frank favored by the financial sector.

“OLA is an important tool to ensure economic resiliency, protect taxpayers and codifies that no institution is too big to fail,” said Anthony Cimino, head of government affairs at the Financial Services Rountable, a major banking trade group.

“Today’s Treasury report appropriately recommends OLA remain in place. We look forward to engaging policymakers on suggested reforms to enhance the bankruptcy process to provide further economic stability while promoting responsible economic growth.”

House Financial Services Committee Chairman Jeb Hensarling (R-Texas) said the Treasury report is “inconsistent” with the financial regulatory principles outlined in Trump’s 2017 executive orders mandating the analysis.

“Taxpayers must never be forced to pay the price when big banks fail,” Hensarling said. “Encouraging economic growth, strong capital, and market discipline, not the arbitrary discretion of federal regulators, is the only way to maintain vibrant and healthy financial markets.”

Hensarling is the architect of the CHOICE Act, the House GOP’s effort to undo much of Dodd-Frank. The bill, which fully repeals OLA, passed the House in June 2017 but will likely be ignored by the Senate.

Joo-Yung Lee, managing director at Fitch Ratings, said a full OLA repeal would pose “significant systemic risk in a crisis” for banks, but that the Treasury proposal appears to have “limited implications.”

“Most of the changes proposed in the report require legislative change, which Fitch believes is more challenging than regulatory changes,” Lee said. “The ultimate impact to creditors will depend on what, if anything is changed.”

Changes to OLA, which would likely be opposed by most Democrats, are not included in the bipartisan Senate bill to pare back Dodd-Frank rules. Any attempt to revise Dodd-Frank would need the support of eight Senate Democrats to clear a filibuster.

Updated at 1:34 p.m.