FDIC postpones rule to dismantle unstable banks

WASHINGTON — The Federal Deposit Insurance Corp. on Monday postponed approving a rule that would dismantle a failing Lehman-like megabank in a way so its collapse doesn't cause collateral damage to the markets.

The agency had expected to adopt a rule setting up the mechanism, which is based on the Dodd-Frank Act, but decided instead to discuss a proposal on the subject with the goal of introducing it in the coming weeks.

The agency also on Monday approved a rule requiring depository institutions to share some of the risk when issuing packaged mortgage securities. The agency is requiring that banks hold at least 5 percent of the credit risk of securities they package and sell unless adequate underwriting standards are in place.

The agency expects to discuss its preliminary proposal to dismantle a failing megabank with a newly formed Financial Stability Oversight Council before approving it. The agency will also introduce a second proposal on the subject in the first quarter of 2011, which could include measures to identify how taxpayer funds used in the process will be recouped from the financial industry.

FDIC Chairman Sheila Bair said there are some "important issues" that must be clarified, such as how the agency will treat "similarly situated creditors" when dismantling a megabank.

The Dodd-Frank Act would permit the Treasury to use taxpayer funds to make pay-outs to creditors and counter-parties of a failing megabank so they don't fail as well, which would cause a ripple effect to the economy. In addition to charging financial institutions a fee to recoup taxpayer funds, the dismantling mechanism also would sell assets of the failing megabank, which would be used to cover costs to taxpayers.

But Bert Ely, bank consultant at Ely & Company in Alexandria, Va., said he thinks that the FDIC is grappling with what to do in a scenario in which there are two similarly situated creditors, with the same liquidation status, but one creditor receives better treatment than the other because the agency deems that its collapse is a greater threat to financial stability.

"There is a lot of concern that the FDIC will be acting in an arbitrary manner when making pay-outs to creditors, and there is a question about whether there is sufficient judicial review," Ely said.

Ely said he expects — should Republicans take control of Congress in the mid-term elections — the judiciary committees to hold hearings about whether the Dodd-Frank Act granted the FDIC too much discretion in deciding how to structure pay-outs to the failing bank's creditors and counter-parties. "This is going to be a big battle," he said.

The agency voted 4-1 to approve its risk-retention rules for securitizers, with the one dissenting vote made by FDIC member John Walsh, acting comptroller of the currency.

Walsh argued that the rule, which applies only to depository institutions registered with the FDIC, would create a bifurcation in the securitization market because it doesn't apply to financial institutions that are not FDIC-insured depository institutions. The Dodd-Frank Act, which was approved in July, requires bank regulators to write risk retention rules for all financial institutions, not just depository institutions.

"It is my view that we should extend the safe harbor and pursue the process set out in Dodd-Frank to develop a consistent policy for the entire financial system and I believe that process would be less disruptive," Walsh said.

Bair argued in defense of the measure, arguing that the proposal has been under consideration at the FDIC for nearly a year and it conforms to the Dodd-Frank statute.

"The rule is fully consistent with the clear mandate of the Dodd-Frank Act to apply a 5 percent risk retention requirement unless sufficiently strong underwriting standards are in place to counter incentives for lax lending created by the originate-to-distribute model," Bair said.