Federal regulators should consider ensuring secured creditors face losses when banks fail, the head of the Federal Deposit Insurance Corp. (FDIC) says. However, such an action could make for an even worse credit crunch during periods of financial turmoil and weaken recovery efforts, according to many analysts.
Secured creditors, normally protected from losses if a bank fails, would tread more carefully and monitor the riskiness of a bank before investing if they were held more accountable, FDIC Chairwoman Sheila Bair said in a speech to the International Institute of Finance (IIF) in Istanbul. The speech was a part of Bair's reiteration that the U.S. government's "too big to fail" doctrine for banks should be scrapped.
"We need to establish an effective and credible resolution mechanism to ensure that market players will actively monitor and keep a handle on risk-taking," she said. "This could involve limiting their claims to no more than say 80% of their secured credits," Bair said, adding "this would ensure that market participants always have a 'skin in the game.'"
But Bair's proposal, which isn't a part of the Obama administration's regulatory overhaul, would likely increase banks' cost of funding and make it harder to find long-term financing because creditors would be watching closely for any signs of trouble, according to William Black, associate professor of economics and law at the University of Missouri-Kansas City and a former bank regulator.
"It would make it gratuitously more expensive for banks to raise funds, even on a secured basis," Black told Bloomberg News.
While Scott Talbott, senior vice president of government affairs for the, a Washington-based industry group, said Bair's plan "would cast doubt over existing financing arrangements from auto dealers and AIG to mortgages."
"Ultimately, it could weaken the recovery efforts," he added.
While Bair conceded her proposal could increase borrowing costs for banks, she said it also would encourage them to reduce their reliance on short-term funding, make the broader financial system more resilient, and reduce the burden of a failure on unsecured creditors, who would then be less likely to need a government bailout.
But such a proposal could raise the premiums of secured creditors, University of Missouri-Kansas City's Black says.
"If you could completely shaft the secured creditors, it's always good for the unsecured creditors," Black said. "The secured creditors are likely to figure that out and demand a larger risk premium if you try to ambush them."
Bair said the current method of guaranteeing secured creditors and repurchase agreements – also known as "repos" – as nettable financial contracts may weaken the financial markets. These contracts generally take a higher priority over other claims in bankruptcy cases. Repurchase agreements are usually used to raise short-term capital through vehicles such as T-bills, with maturities ranging from one to six months.
The market for these repurchase agreements would be adversely affected and in turn the credit markets if legislators enacted Bair's proposal, says Money Morning Contributing Editor Martin Hutchinson, a leading banking expert.
"It would effectively close the repo market in periods of financial stress, and thereby hugely damage credit markets in such periods," Hutchinson said.
Still, Bair did acknowledge concerns raised by Deutsche Bank AG (NYSE: DB) Chief Executive Officer and IIF Chairman Josef Ackerman that regulators "could go too far" and halt any hopes of an economic recovery.
"The point is well taken about over-regulation because banks are heavily regulated already," Bair told Bloomberg, adding that the FDIC wants to see bank capital requirements rise over time, not "spike up" in a way that could hurt lending as the global economy starts its recovery. She also said that the current doctrine of repaying secured creditors when a bank fails could be a source of systemic risk.
One major advantage of limiting secured creditors claims, Bair said, is that all general creditors "could receive substantially greater advance payments to stem any systemic risks without the extensive delays typically characteristic of the bankruptcy process."
The FDIC, now with a negative insurance fund for banks with deposits, has seized a total of 98 failed banks this year, compared with 25 in all of 2008.
News and Related Story Links
- Money Morning:
Obama's Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street
- Bloomberg News:
Bair Says Secured Creditors Should Pay for Failures
- Money Morning:
Banks Satisfied on FDIC Decision, but Will They Still Lend?