By Steve Seuser
This article documents the legal framework for too-big-to-fail banks and other banks with derivative investments that put their depositors at high risk in the event of bankruptcy. It is intended to assist District of Columbia elected officials, city administrators, other concerned stakeholders, and citizens to understand and respond to the legal framework that binds federal regulatory agencies and courts in the event of bank failures, including:
- the international Financial Stability Board’s policy framework and lists of too-big-to-fail banks
- the Federal Deposit Insurance Corporation’s legal framework to seize some bank deposits and convert them to stock in the bank during bankruptcy
- the super-priority status of derivatives under U.S. Chapter 11 bankruptcy law, which could easily wipe out all depositors’ account balances in a bankruptcy. This issue is ineffectively addressed in Dodd-Frank
- legal precedents that have wiped out individual investment accounts
- the false security of collateral for public deposits
- options for public finance officials to maintain the safety and soundness of public funds
These legal issues are introduced in the video Public Funds At Risk in The Big Banks.
In November 2011, the international Financial Stability Board (FSB) published a list of globally systemically important financial institutions (G-SIFIs), as part of its effort to reduce risk to the global financial system if one of these “too-big-to-fail” institutions became insolvent. The 2011 Policy Measures to Address Systemically Important Financial Institutions includes an overview of the proposed policy recommendations and a listing of the 29 financial institutions included in 2011. In November 2012, the FSB produced an updated list and policy actions entitled Update of group of global systemically important banks (G-SIBs).
These two documents rely on an underlying FSB policy document entitled Key Attributes of Effective Resolution Regimes for Financial Institutions that provides more specific guidance to countries about resolving failures of too-big-to-fail banks.
Banks included on the FSB list of too-big-to-fail banks should not be seen as more stable than other banks. While the FSB recommends increasing the capital requirements for these too-big-to-fail banks, the levels of capitalization required are actually quite low. The capitalization of any or all of these banks could be completely wiped out by another financial market crisis similar to 2008-09 or any significant losses from investments in derivatives, which have a notional value of over $700 trillion world wide. The world’s total annual GDP is $70 trillion.
In the U.S. and Great Britain, the Federal Deposit Insurance Corporation (FDIC) and the Bank of England in 2011 jointly published Resolving Globally Active, Systemically Important, Financial Institutions. This document provides the legal framework for seizing deposit accounts in failed banks and converting them to stock in the reconstituted bank in order to preserve the soundness of the bank. This background piece describes the legal position of depositors as unsecured creditors in bankruptcy. The FDIC’s document also uses the terms “unsecured creditors” and “unsecured debt holders” to include depositors in the following statement (p. 8):
The unsecured debt holders can expect that their claims would be written down to reflect any losses that shareholders cannot cover, with some converted partly into equity in order to provide sufficient capital to return the sound businesses of the G-SIFI to private sector operation.
In addition to the FDIC encouraging big banks to seize deposits during bankruptcy to maintain the stability of the banking system as it protects the FDIC Insurance Fund from being totally depleted by over-sized bank failures, depositors in the U.S. face an additional risk of loss under U.S. bankruptcy law among all sizes of banks that invest in derivatives. During bankruptcy, derivative counterparties receive “super-priority” status above all other creditors, including depositors. This means that derivative holders will get all of the bank’s assets before any other creditors, including depositors, are paid. Harvard Law Professor Mark J. Roe describes the legal framework created under federal bankruptcy law in his Stanford Law Review article The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator. Roe concludes that “the major [Dodd-Frank] financial reform package Congress enacted in response to the financial crisis lacks the needed changes” to limit derivative super-priority risk.
The 2011 collapse of derivatives broker MF Global has resulted in nearly $1.6 billion in potential losses from customer accounts and established a precedent for the super-priority status of other claimants ahead of depositors. Derivatives counterparty JP Morgan Chase received super-priority status against customers for their claims on MF Global assets. While MF Global was not a bank, the legal arguments for super-priority status ensure that derivatives counterparties and large investment firms will structure their agreements to receive priority status during the liquidation of bank (and customer) assets. In a best case scenario, depositors will regain access to their funds after years of litigation.
Public finance officials often establish agreements with banks that require banks to post collateral for their public deposits. This collateral creates a false sense of security contrary to the established legal precedents. Mark Roe writes that “the Bankruptcy Code bars the debtor’s creditors from suing the debtor for repayment, bars them from trying otherwise to collect debts due from the bankrupt, and — if the creditors are secured — bars them from immediately seizing or liquidating their security” (p. 547) and “the recipient could not keep the collateral, but would have to return it for all creditors’ pro rata benefit” (p. 551). For banks holding derivatives, derivatives counterparties will exercise their super-priority status to raid all bank assets on the eve of bankruptcy, including the collateral supposedly held for public deposit accounts.
The risk of losing deposits in bankruptcy provides a strong incentive for public agencies, pension funds, business, nonprofits, and individuals to move their deposits quickly to institutions that do not invest in derivatives. In particular, officials overseeing the safety and soundness of pension funds, public funds, nonprofit funds, or other types of investments have a fiduciary responsibility to protect their institutions’ assets. This includes moving investments to local financial institutions such as credit unions and local banks and the option proposed by the DC Public Banking Center for DC government to establish the DC Public Bank and deposit its funds there. The DC Public Bank option also provides many other benefits to DC government, businesses, residents, and the overall economy.
Banks in the D.C. Market includes local banks at the bottom of the list. In addition, credit unions represent a viable alternative to risky banks for many depositors and borrowers. A list of credit unions operating in jurisdictions throughout the U.S., including the District of Columbia, is available through the National Credit Union Administration’s Locator. The U.S. Office of the Comptroller of the Currency tracks derivatives holdings on a quarterly basis. The OCC’s most recent report from March 31, 2013 shows the top 25 banks holding derivatives.