Federal Reserve Vice Chair Responds to Critics of the GSIB Resolution Process

Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System, described the steps that have been taken to reduce the likelihood and the severity of a failure of a major U.S. financial institution, including the resolution plans ("living wills") that large banking organizations are required to formulate, the adoption of Title II of Dodd-Frank, which provides for the orderly liquidation of financial companies, and the imposition of "total loss-absorbing capacity" and long-term debt requirements on bank holding companies (including U.S. intermediate holding companies of foreign banking companies).

Mr. Fischer addressed several criticisms that have been leveled against these measures. First, some critics have claimed that the Bankruptcy Code is sufficient to address the resolution of a large financial company. Mr. Fischer observed that the Bankruptcy Code does not require bankruptcy judges to take financial stability into account, and does not provide stability-enhancing features such as access to the orderly liquidation fund and a temporary stay to allow qualified financial contracts to be transferred.

Second, critics have claimed that Title II essentially codifies "too big to fail," that is, the anticipation that the government will backstop losses at major financial firms rather than suffer the consequences of their failure. To this claim, Mr. Fischer responded that the U.S. system will instead require private investors to bear the cost of recapitalizing a failed firm through the forced conversion of long-term debt to equity. The orderly liquidation fund, by contrast, is meant to provide temporary liquidity but not to provide permanent recapitalization. If losses are incurred by the fund, they can be recovered through an assessment on financial firms.

Finally, Mr. Fischer responded to those who argue that requiring banking organizations to issue long-term debt, rather than additional equity, might result in an undesirably high degree of leverage. Mr. Fischer asserted that equity capital requirements are important, but that regulators must take steps not only to reduce the likelihood of insolvency, but also the negative consequences that result from it. He noted that equity capital would be exhausted at the point of insolvency, whereas long-term debt would retain its loss-absorbing capacity. Moreover, he argued, many firms would not respond to the requirements by increasing their leverage, but rather would shift their liabilities from ineligible debt instruments to eligible long-term debt. Mr. Fischer suggested that the existence of loss-absorbing capacity should reduce the incentives for short-term creditors to "run" from a financial company when it experiences financial difficulties.

Vice Chair Fischer delivered his remarks at the Resolution Riksbank Macroprudential Conference in Stockholm, Sweden.