While the subject continues to be hotly contested, at least one regulator, Federal Deposit Insurance Corp. Chairman Sheila Bair, is satisfied that the pending regulatory reform bill would put a stop to government bailouts.

In an interview on Wednesday, Bair, who has advised lawmakers on both sides of the aisle on the issue, answered questions about what the bill would — and would not — allow.

Would this bill perpetuate bailouts?

SHEILA BAIR: The status quo is bailouts. That's what we have now. If you don't do anything, you are going to keep having bailouts. Bankruptcy doesn't work — we saw that with Lehman Brothers.

But does this bill stop them from happening?

BAIR: It makes them impossible and it should. We worked really hard to squeeze bailout language out of this bill. The construct is you can't bail out an individual institution — you just can't do it.

In a true liquidity crisis, the FDIC and the Fed can provide systemwide support in terms of liquidity support — lending and debt guarantees — but even then, a default would trigger resolution or bankruptcy.

Critics say the bill would let the FDIC pick and choose creditors to pay back in a resolution. Is that a form of a bailout?

BAIR: We've always had that. You close a bank, you set up a bridge bank, and you have IT service providers, property upkeep — they are general creditors. You want to keep paying them to keep the services going.

That's just an example. You need to keep that kind of thing going to maintain the franchise value. You have the power to do that in bankruptcy too.

The FDIC will provide detailed disclosure of any creditor that receives more than others of the same class. Let's be clear, this is limited only to those essential to maintain critical functions and preserve value of assets to benefit all creditors. It will not include bondholders or shareholders.

Would the Fed's 13-3 emergency powers allow a bailout?

BAIR: Not for an individual institution, no. This is more like the debt guarantee program, or the Transaction Account Guarantee program, which we just extended yesterday. It's for those types of programs. … This would only help healthy institutions. And if there were a default on those programs, it would automatically trigger resolution or bankruptcy and the government would have priority claim off the top.

How would that play out?

BAIR: Let's say Bank X has TLGP debt and they default on their debt payments. So the FDIC obviously would make good on its guarantee to the senior debt holders but this would allow us to either put them in resolution or put them in a bankruptcy and we would have priority claim to be repaid.

Is there a way around that?

BAIR: It's resolution or bankruptcy, no questions. It is mandatory — that's the whole idea. You have to do one. It's a terrible incentive not to default and that's what you want. You want a harsh process. You don't want these guys running to the government for assistance.

The trade-off needs to be, 'You are in trouble, fine. We have this nice, clean, orderly resolution process now and we are going to shut you down. We are going to haircut your shareholders and creditors, and we will set up a bridge bank, and we will sell you off.' That's what is going to happen. That will be a powerful disincentive to come to the government. I think it will only be used when they are truly failing.

But if we ran into the same kind of situation as 2008, won't the government find some way to prop up the big banks if several were in danger of failing?

BAIR: If there is a true systemwide problem, that's why you have systemwide liquidity support — through either a debt guarantee program or lending program by the Fed. It would have to be generally available. Again, if there is a default on it, that automatically triggers a bankruptcy or resolution; regulators can decide which.

If this had been law prior to 2008, would we have seen the bailouts that took place? Would we have seen capital injections into banks?

BAIR: No. You could not do an AIG, Bear Stearns, or any of that. Those were all one-off things, capital or asset guarantee transactions. This bill would only allow system-wide liquidity support which could not be targeted at an individual firm. You can't do capital investments at all, period. It's only liquidity support. No more capital investments. That's banned under all circumstances.

You can do systemwide liquidity support. But you can't do anything on an individual basis. They would have to be generally available.

Do you see any way left for the government to bail out a financial institution?

BAIR: No, and that's the whole idea. It was too easy for institutions to come and ask for help. They aren't going to do that. This gives us a response: "Fine, we will take all these essential services and put them in a bridge bank. We will keep them running while your shareholders and debtors take all your losses. And oh, by the way, we are getting rid of your board and you, too."

The whole idea is to get market discipline back.

That's what ending "too big to fail means." It means debtors and shareholders understanding their money is at risk and especially the debtholders starting to look at the balance sheet of these big institutions and asking their own hard questions instead of relying on government support.

Will this bill really end "too big to fail"?

BAIR: I think it will go a long way.


This story has been reprinted with permission from American Banker.

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