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Financial Company Bankruptcies: Need to Further Consider Proposals' Impact on Systemic Risk

GAO-13-622 Published: Jul 18, 2013. Publicly Released: Jul 18, 2013.
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Highlights

What GAO Found

Because the Bankruptcy Code (Code) does not specifically address issues of systemic risk, experts have proposed giving financial regulators a greater role in financial company bankruptcies. However, according to experts at a GAO roundtable, such proposals may have limited impact and raise certain implementation issues. For example, a proposal to require notification before bankruptcy depends on when (number of days) notification would be required and with whom (which regulators). Experts noted financial companies may not know that they will declare bankruptcy even a few days before the event and could have many regulators to notify. Experts also noted ways regulators already can compel financial companies to declare bankruptcy, and that changing the Code to allow regulators to place firms in bankruptcy involuntarily could temporarily place a firm in an uncertain legal status, eroding firms' values and endangering market stability. Other options, such as having regulatory standards forcing the firm into bankruptcy, could improve the likelihood of an orderly resolution, according to these experts. Although the proposals reflect the need to minimize systemic effects of financial company bankruptcies, the Financial Stability Oversight Council (FSOC)--charged with responding to threats to financial stability--has not considered changes to the Code. Consideration could improve FSOC's ability to address such threats in a timely and effective manner.

Experts emphasized that funding is needed to facilitate orderly and effective financial company bankruptcies. They generally agreed that prohibiting all federal funding or guarantees of private funding likely would lead to fire sales of assets. They agreed that fully secured funding should be used only to provide short-run liquidity and not for bailouts of insolvent firms' creditors. Experts suggested a private-sector fund could be created for this purpose. Such funds could be collected voluntarily, through routine assessments (before a bankruptcy), or through a facility similar to the one created for the Orderly Liquidation Authority, which allows federal funding at the time of a bankruptcy and later recovery of funds through an industry assessment. Experts noted some difficulties associated with these proposals, including determining whether a firm was insolvent or needed liquidity, and identifying permissible types of collateral.

Generally, experts did not agree on advantages or disadvantages of proposals to change the safe-harbor treatment of qualified financial contracts (QFC). The Code exempts QFCs, such as derivatives, from the automatic stay that generally prevents creditors from taking company assets in payment of debts before a case is resolved. It also exempts QFCs from provisions that allow bankruptcy judges to "avoid" contracts entered into within specified times before a filing. Proposals to change QFC treatment--subjecting all or some contracts to the automatic stay on a permanent or temporary basis and removing the avoidance exemptions--might address issues raised by extensive contract terminations in the early days of financial company bankruptcies. Experts said it was unclear what lessons should be learned from those experiences. Many noted that narrowing the exemptions would reduce the size of derivative markets, but views varied about whether such narrowing would increase or decrease systemic risk. Some experts said that the current safe harbors decrease systemic risk, while others said they increase it by making firms more dependent on less-reliable short-term financing.

Why GAO Did This Study

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) mandates that GAO report on an ongoing basis on ways to make the Code more effective in resolving certain failed financial companies. This report examines advantages and disadvantages of certain proposals, based on those identified in GAO's first report, to revise the Code for financial company bankruptcies--specifically, proposals (1) to change the role of financial regulators in the bankruptcy process; (2) affecting funding of financial company bankruptcies; and (3) to change the safe-harbor treatment of QFCs. For this report, GAO held two expert roundtables in which participants evaluated the proposals using criteria for orderly and effective bankruptcies that GAO developed in earlier reports. The criteria are minimizing systemic risk, avoiding asset fire sales, ensuring due process, maximizing value, and limiting taxpayer liability. GAO identified these criteria by reviewing literature and interviewing government officials, industry representatives, and legal and academic experts.

Recommendations

FSOC should consider the implications for U.S. financial stability of changing the role of regulators and the treatment of QFCs in financial company bankruptcies. FSOC agreed that a disorderly financial company bankruptcy could pose risks to financial stability, but stated that it would be premature for FSOC to consider proposals to change the Code. GAO reiterated that its recommendation was consistent with FSOC’s statutory role and responsibilities.

Recommendations for Executive Action

Agency Affected Recommendation Status
Financial Stability Oversight Council To fulfill FSOC's role under the Dodd-Frank Act to identify and respond to threats to financial stability, the Secretary of the Treasury, as Chairperson of FSOC, in consultation with other FSOC members, should consider the implications for U.S. financial stability of changing the role of regulators and narrowing the safe harbor treatment of qualified financial contracts in financial company bankruptcies.
Closed – Implemented
The Financial Stability Oversight Council engaged in a variety of actions to address risks to financial stability posed by the failure of one or more financial companies which address our recommendation. These efforts have included establishing in May 2015 a new staff-level Regulation and Resolution Committee to further facilitate communication on the implementation of the orderly liquidation authority and on resolution plans, which are a critical element of the bankruptcy process for large financial companies; and continuing to engage in real-time monitoring and communication about risks to financial stability. Additionally, Treasury evaluated potential legislative changes to bankruptcy laws, and Treasury and other Council member agencies have worked to make progress regarding the cross-border resolution of a global systemically important financial institution (G-SIFI). Regarding potential legislative changes, Treasury has monitored and evaluated various legislative proposals, such as H.R. 5421 (the Financial Institution Bankruptcy Act of 2014), which would replace the safe harbor treatment of qualified financial contracts with, in essence, a 48-hour stay in covered financial corporation bankruptcies. Further, the Council's 2015 annual report made recommendations and noted progress in mitigating two widely recognized obstacles to a cross-border resolution of a G-SIFI. Specifically, the annual report recommended action on the international protocol dealing with qualified financial contracts. In order for the recommendation to become fully effective, the protocol for covered transactions among the 18 firms would require the issuance of regulations in the United States and foreign countries. The Council recommended that the appropriate member agencies take steps, including through notice-and-comment rulemaking, so that the provisions of the protocol become effective and to encourage a more widespread adoption of contractual amendments to International Swaps and Derivatives Association documentation and other financial contracts. The Council also recommended that regulators and market participants continue to work together to facilitate industry-developed mechanisms to address similar risks in other financial contracts governed by standardized market documentation. During the Council's September 4, 2014, and May 19, 2015 meetings, the Council received an update on resolution plans from the Federal Reserve Board and the FDIC. Additionally, the Council approved the charter for the Regulation and Resolution Committee, which among other things, specifies the duties of that committee. The Council issued a notice of proposed rulemaking on Qualified Financial Contracts Recordkeeping Related to Orderly Liquidation Authority; Proposed Rule 31 CFR Part 148, published in the Federal Register on January 7, 2015. Section 210(c)(8)(H) of the Dodd-Frank Act requires consultation with the FDIC, and the Council's consultation was extensive in the lead up to the publication of the proposed rule. Following the closure of the comment period on April 7, 2015, Treasury began consultation with the FDIC on the final rule. These consultations are still in progress and work on the final rule is ongoing.

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Banking regulationBankruptcyBrokerage industryCommodity futuresContract performanceFederal fundsFederal reserve banksFinancial institutionsInsurance companiesRegulatory agenciesReorganizationRight to due processFinancial regulation