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A Continuum Approach to Systemic Risk and Too-Big-To-Fail, 6 Brook Brooklyn Journal of Corporate, Financial & Commercial Law Volume 6 | Issue 2 Article 1 2012 A Continuum Approach to Systemic Risk and Too- Big-to-Fail Cheryl D. Block Follow this and additional works at: https://brooklynworks.brooklaw.edu/bjcfcl Recommended Citation Cheryl D. Block, A Continuum Approach to Systemic Risk and Too-Big-to-Fail, 6 Brook. J. Corp. Fin. & Com. L. (2012). Available at: https://brooklynworks.brooklaw.edu/bjcfcl/vol6/iss2/1 This Article is brought to you for free and open access by the Law Journals at BrooklynWorks. It has been accepted for inclusion in Brooklyn Journal of Corporate, Financial & Commercial Law by an authorized editor of BrooklynWorks. ARTICLES A CONTINUUM APPROACH TO SYSTEMIC RISK AND TOO-BIG-TO-FAIL Cheryl D. Block This Article highlights differences between principle and practical implementation of prudential financial regulation and resolution rules for failing financial institutions. In principle, prudential regulation gradually enhances enforcement along a risk-based continuum. Under this approach, systemically important financial institutions, which pose greater potential threats to economic stability, theoretically should be more strictly regulated than other financial entities. In reality, however, regulators often opt not to fully enforce prudential financial regulations against such large institutions, a practice sometimes referred to as regulatory forbearance. In ironic contrast, rules for resolving failing financial institutions have increasingly restricted regulators’ options, often limiting them to a binary choice between allowing the entity to fail and providing a government “bailout.” In reality, however, regulators have flexibly responded to failing institutions along a continuum ranging from little or no intervention to public rescue. Despite Dodd-Frank’s attempt to limit this “reality,” regulators are likely to continue the flexible exercise of their resolution authority. In this Article, I argue that a continuum-based approach is important for both prudential regulation and the resolution of failing firms. With respect to regulation, this approach should ensure proper implementation of existing gradually enhanced prudential regulatory rules. With respect to resolution, this approach acknowledges and accepts the range of existing and potential government responses to failing financial institutions. Rather than pretend to rid the system of bailouts, policy makers should develop an equitable and transparent process and substantive criteria for allocating risk in the event of systemically important financial institution failures. TABLE OF CONTENTS INTRODUCTION .......................................................................................... 292 © 2012 by Cheryl D. Block. All Rights Reserved. Professor of Law, Washington University School of Law. I would like to thank Dean Kent Syverud and the Washington University Law School for generous research support. Thanks also to Professors Susan Block-Lieb, Emily Hughes, Dan Keating, Arthur Wilmarth, David Zaring, and participants in the Brooklyn Law School 2011 Comparative Approaches to Systemic Risk Allocation Symposium, and to Dr. Chad K. McDaniel. Thanks also to Dorie Bertram, Washington University Law Library, Director of Public Services; Judith Stark, Washington University Law Library Documents Librarian; and to research assistants, Charlena Aumiller, Jonah Brotman, David Freed, Raquel Frisardi, Justin Kanter, and Danilo Santucci. 290 BROOK. J. CORP. FIN. & COM. L. [Vol. 6 I. REGULATORY RESPONSE TO SYSTEMIC RISK: PRINCIPLE VERSUS REALITY ................................................................................ 298 A. PRUDENTIAL BANK REGULATORY LANDSCAPE ........................... 298 1. Primary Bank Regulators ....................................................... 298 2. Prudential Bank Regulation ................................................... 300 a. General Risk Continuum Principle .................................. 300 b. Regulatory Practices Inconsistent with Continuum Principle ........................................................ 301 c. Efforts to Limit Regulatory Forbearance: Prompt Corrective Action ............................................................ 309 B. PRUDENTIAL NONBANK FINANCIAL INSTITUTION REGULATORY LANDSCAPE BEFORE DODD-FRANK...................... 313 1. Limited Early Intervention Provisions for Nonbank Financial Companies .............................................................. 313 2. Discount Window as a Substitute or Supplement to Forbearance ............................................................................ 315 C. DODD-FRANK’S REGULATORY RESPONSE TO SYSTEMIC RISK .............................................................................................. 315 1. General Response to Regulatory Weaknesses Exposed by Crisis .................................................................. 315 2. Dodd-Frank’s Regulatory Response to Systemic Risk: Commercial Banks ....................................................... 317 3. Dodd-Frank’s Regulatory Response to Systemic Risk: Nonbank Financial Institutions and Bank Holding Companies ............................................................... 318 a. Financial Stability Oversight Council and Heightened Regulation for “Covered” Financial Companies ....................................................................... 318 b. Enhanced Prudential Regulation and Early Remediation Mandates: Progressive Risk Principles ......................................................................... 319 c. Entities Posing “Grave Threats” to Financial Stability ........................................................................... 321 4. Covered Entities and “Cliff Effects” ...................................... 323 a. Bank Holdings Companies .............................................. 323 b. Systemically Important Financial Institutions ................. 325 D. REGULATORY RESPONSE SUMMARY: RISK-CONTINUUM PRINCIPLES VERSUS BINARY REALITY ........................................ 326 II. THE RESOLUTION AUTHORITY RESPONSE TO SYSTEMIC RISK ........... 328 A. RESOLUTION DEFINED .................................................................. 328 1. Prudential Regulation and Resolution Compared .................. 328 2. Fuzzy Boundaries .................................................................. 331 a. Early Fuzzy Boundaries Between Regulation and Resolution ........................................................................ 331 2012] A Continuum Approach 291 b. Ex Ante Rules with Ex Post Functions and Ex Post Rules with Ex Ante Effect ....................................... 332 B. MANAGING THE BANK RESOLUTION PROCESS ............................ 333 1. The Need for Resolution Flexibility ...................................... 333 2. Basic FDIC Bank Resolution Methods .................................. 334 C. SYSTEMIC RISK AND BANK FAILURES ......................................... 335 1. Conflicting FDIC Policy Tensions ......................................... 335 2. Open Bank Assistance and the Evolution of Too-Big- to-Fail ..................................................................................... 336 a. Essential to the Community Determinations ................... 336 b. The Birth of Too-Big-to-Fail ........................................... 337 3. Statutory “Systemic Risk” Rules and the Purported Death of Too-Big-to-Fail ....................................................... 338 4. Premature Reports of the Death of Too-Big-to-Fail .............. 340 D. DODD-FRANK RESOLUTION REFORMS ......................................... 341 1. Federal Reserve Discount Window Lending ......................... 341 2. Restrictions on FDIC Systemic Risk Exception Flexibility ............................................................................... 342 3. Dodd-Frank Resolution Response to Systemic Risk ............. 342 a. Systemic Risk Determinations and Orderly Liquidation Authority ...................................................... 342 b. Funding Orderly Liquidations ......................................... 345 c. Mandatory Liquidation .................................................... 346 III. THE PRIVATE-PUBLIC RESOLUTION CONTINUUM .............................. 347 A. INTRODUCTION ............................................................................. 347 B. THE PRIVATE END OF THE RISK ALLOCATION CONTINUUM ................................................................................. 348 1. No Risk Allocation Mechanism is Purely Private ................. 348 2. Ex Ante Private Risk Allocation ............................................ 349 a. Private Insurance ............................................................. 349 b. Hedging and Derivatives ................................................. 350 c. Securitization ................................................................... 351 3. Ex Post Private Allocations ................................................... 352 a. Private Rescue Efforts by Stakeholders .......................... 352 b. Rescues by Competitors or Other Private Parties ............ 352 C. QUASI-PUBLIC RISK ALLOCATION MECHANISMS ........................ 354 1. The Private Tort Regime Versus Government Criminal and Civil Collection Efforts .................................... 354 a. Private Tort Litigants ....................................................... 354 b. Government as Litigator .................................................
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