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Net Net: Promoting innovation and managing change

Will Resolution Authority Get Tested?

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With shares of two of the largest U.S. banks falling by nearly 20 percent Monday, the resolution authority of financial regulators to deal with failing banks is being quietly tested.

And so far it seems to be failing.

Bank of America fell by 20 percent Monday on heavy volume. It has been down as much as 32.74 percent over the past five trading sessions, although it seems to be regaining a little today.

Shares of Citigroup suffered a double digit decline, as well. And they too are making a comeback today.

Naturally there's chatter. Some people are asking whether Bank of America might have to raise capital.

“A lot of people think the bank will have to raise capital, and any major capital raise will be massively dilutive," said Paul Miller, an analyst at FBR Capital Markets, according to Reuters. "The bank just can't get its hands around the liabilities it's facing."

But Bank of America insists that it does not need to raise capital.

Bank of America will explain to almost anyone who will listen that they are in a far stronger position than they were in 2008 and 2009. I'm sure Citigroup would say the same thing if people asked it about them.

They have more capital. More liquidity. Everything is far in excess of regulatory requirements.

But regulatory requirements are not a guarantee against failure. They aren’t meant to operate that way at all. The market is not bound by the rules of regulators when deciding that a bank has failed.

Bear Stearns had capital ratios well in excess of what supervisory standards required at the very moment of its collapse.

What we’re seeing is a fundamental problem with the concept of resolution authority. It is supposed to prevent a disorderly dissolution of an important financial entity by giving regulators the time to plan an orderly wind-down. But there is no trigger for when regulators should step in. It’s entirely discretionary.

Sure, BAC will likely weather this storm. Still, you have to ask: if losing a nearly a third of your market cap in five trading sessions is not a trigger for regulators to at least come in and begin discussing the possibility of resolution, what could be?

The FDIC’s alternative-universe scenario for the resolution of Lehman Brothers imagines that the FDIC and the Federal Reserve would have begun due diligence and planning for resolution under Dodd-Frank once it became clear that Lehman had not “found an early private sector solution.”

But when does that become clear? The FDIC report makes it clear that Lehman’s “senior management discounted the possibility of failure until the very last moment.”

What was needed, according to the FDIC, was for regulators to make clear that the Lehman management couldn’t afford to wait any longer.

That if they didn’t act, the government would step in.

To convey this point to Lehman and its Board of Directors, the FDIC could have participated in a meeting in the spring of 2008, together with Lehman’s Board of Directors, the Federal Reserve, and the SEC, to outline the circumstances that would lead to the appointment of the FDIC as receiver for one or more Lehman entities, and what that resolution would entail. The regulators would have emphasized that any open-company assistance or “too big to fail” transaction would be unavailable, and that the alternative to a sale of the company or a substantial capital raising would be a bankruptcy under the Bankruptcy Code or a resolution under Title II with no expectation of any return to shareholders.

So now we’re faced with Bank of America watching nearly a third of its market capitalization get evaporated, seeing its credit default swaps soar, and reacting by “discounting the possibility of failure.”

Citigroup looks healthier, although only by comparison.

Bank of America told me it is in regular communication with its regulators. But it said that there was no planning for potential resolution underway. A source at Citigroup said the same thing.

Indeed, recent market downturns could likely be just a bump in the road for the banks. The point here is not so much about the state of this or that particular bank, but more about the regulatory apparatus designed to monitor the health of banks. Whether or not the patient is having a heart attack...and we certainly hope the patient isn't ...would the monitor even pick it up?

If resolution authority was supposed to provoke banks into responding to the apparent collapse of market confidence with new capital raises—even if not required by regulatory standards—it doesn’t seem to work.

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