[Senate Hearing 114-123]
[From the U.S. Government Publishing Office]




                                                        S. Hrg. 114-123


      THE ROLE OF BANKRUPTCY REFORM IN ADDRESSING TOO BIG TO FAIL

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
             FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED FOURTEENTH CONGRESS

                             FIRST SESSION

                                   ON

 EXAMINING THE ROLE OF BANKRUPTCY REFORM IN ADDRESSING TOO BIG TO FAIL

                               __________

                             JULY 29, 2015

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs





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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

MICHAEL CRAPO, Idaho                 SHERROD BROWN, Ohio
BOB CORKER, Tennessee                JACK REED, Rhode Island
DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois                  JON TESTER, Montana
DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
TIM SCOTT, South Carolina            JEFF MERKLEY, Oregon
BEN SASSE, Nebraska                  ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas                 HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota            JOE DONNELLY, Indiana
JERRY MORAN, Kansas

           William D. Duhnke III, Staff Director and Counsel

                 Mark Powden, Democratic Staff Director

                       Dawn Ratliff, Chief Clerk

                      Troy Cornell, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

     Subcommittee on Financial Institutions and Consumer Protection

               PATRICK J. TOOMEY, Pennsylvania, Chairman

            JEFF MERKLEY, Oregon, Ranking Democratic Member

MIKE CRAPO, Idaho                    JACK REED, Rhode Island
DEAN HELLER, Nevada                  CHARLES E. SCHUMER, New York
MIKE ROUNDS, South Dakota            ROBERT MENENDEZ, New Jersey
BOB CORKER, Tennessee                MARK R. WARNER, Virginia
DAVID VITTER, Louisiana              ELIZABETH WARREN, Massachusetts
MARK KIRK, Illinois                  JOE DONNELLY, Indiana
TIM SCOTT, South Carolina

             Geoffrey Okamoto, Subcommittee Staff Director

       Lauren Oppenheimer, Democratic Subcommittee Staff Director

                                  (ii)


















                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, JULY 29, 2015

                                                                   Page

Opening statement of Chairman Toomey.............................     1

Opening statements, comments, or prepared statements of:
    Senator Merkley..............................................     3

                               WITNESSES

Randall D. Guynn, Partner, Davis Polk & Wardell, LLP.............     4
    Prepared statement...........................................    27
John B. Taylor, Hoover Institution Senior Fellow in Economics, 
  Stanford University............................................     6
    Prepared statement...........................................    66
Thomas H. Jackson, President Emeritus, University of Rochester...     7
    Prepared statement...........................................    76
Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT 
  Sloan School of Management.....................................     9
    Prepared statement...........................................   129

              Additional Material Supplied for the Record

Letter from the National Bankruptcy Conference submitted by 
  Senator Merkley................................................   134

                                 (iii)

 
      THE ROLE OF BANKRUPTCY REFORM IN ADDRESSING TOO BIG TO FAIL

                              ----------                              


                        WEDNESDAY, JULY 29, 2015

U.S. Senate, Subcommittee on Financial Institutions 
                           and Consumer Protection,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 10:01 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Patrick J. Toomey, Chairman of the 
Subcommittee, presiding.

        OPENING STATEMENT OF CHAIRMAN PATRICK J. TOOMEY

    Chairman Toomey. The Committee will come to order.
    Good morning, everyone. I want to start by thanking my 
Ranking Member, Senator Merkley, for joining us this morning in 
addressing a very important topic. I especially want to thank 
the witnesses for taking the time to be here this morning, but 
also for the very, very thoughtful and considerable effort that 
was put into really very comprehensive and very interesting 
testimony. So, thank you for submitting that. Thanks for being 
here this morning.
    I need to explain a little interruption that we are going 
to have in this hearing this morning. We have votes scheduled 
on the Senate floor at 10, two votes, it is my understanding. 
So, Senator Merkley and I have agreed that the best way to 
handle this would be for Senator Merkley and I to give our 
opening statements and then we will recess for the votes. We 
will come back as quickly as we can. Hopefully, the Members of 
the Committee will be able to vote quickly on that second vote 
and return, and then we will welcome the testimony from the 
witnesses. So, with that understood, I will proceed with my 
opening statement and then I will recognize Senator Merkley.
    About 5 years ago, President Obama signed into law the 
Dodd-Frank Act, and he said at the time that, quote, ``There 
will be new rules to make clear that no firm is somehow 
protected because it is too big to fail.'' Unfortunately, in my 
view, the Dodd-Frank Act did not end too big to fail. In fact, 
it enshrined it in law.
    In 2008, taxpayers were forced to pump certainly hundreds 
of billions of dollars in bailouts to floundering financial 
institutions. In response, in my view, rather than eliminating 
taxpayer bailouts, the Dodd-Frank legislation created an 
orderly liquidation authority which contains an explicit and 
limitless ability to draw on taxpayer resources.
    Let me be clear, I opposed the 2008 Wall Street bailouts 
then. I oppose them today. And, I do not want to see any 
bailouts in the future.
    But, Dodd-Frank created an explicit bailout mechanism and 
it appears that the attempt to avoid using that is through 
massive regulation. We have a number of problems with this 
approach.
    First, the SIFI designation itself, in my view, confers 
this too-big-to-fail status, and the over-regulation that then 
is the attempt to avoid the bailout risks turning the financial 
sector into, essentially, public utilities. The regulations 
impose huge costs, both directly in terms of compliance costs 
and a diversion of resources, and the indirect costs that come 
when overly regulated firms are unable to lend as much as they 
otherwise would, unable to innovate as much as they otherwise 
would.
    And, I think we should remember that regulators are neither 
omniscient nor perfect. An institution is likely to eventually 
fail despite the regulators' best efforts. They simply will not 
see it coming. And, in fact, I think a persuasive argument has 
been made that the regulations could even increase the 
likelihood of failures by correlating risks.
    Now, Dodd-Frank deals with the possibility of a SIFI 
failure through the orderly liquidation authority, and I think 
there are many serious problems with this mechanism. One is 
regulators have an almost limitless discretion to force the 
liquidation.
    Second, there is really, under the legislation, there is no 
opportunity for a restructuring, which should be an option 
available to a failing institution.
    Three, the FDIC is essentially designated to control the 
bridge entity that is created in the orderly liquidation 
authority, and I do not know that anyone really believes that 
the FDIC has the expertise to run a Lehman Brothers, for 
instance.
    The FDIC has unlimited discretion in how to treat 
comparably situated creditors, and I think that is completely 
inconsistent with every principle of bankruptcy. It is 
blatantly unfair. Some creditors could be favored relative to 
others who are similarly situated. I think you could argue that 
failure of a financial institution becomes, in fact, more 
likely because this discretion in the hands of the FDIC might 
cause a reasonable fear and suspicion on the part of some 
creditors that they might end up being on the short end of the 
stick in a resolution, and so they have an incentive to pull 
their lines of credit at the first sign of trouble.
    And, as I said earlier, the orderly liquidation authority 
explicitly contemplates a taxpayer bailout. It creates the 
orderly liquidation fund and the Congressional Budget Office 
has scored the cost of this fund as a little over $20 billion 
over the next 10 years. That is their quantification of the 
risk the taxpayers will have to step in and fund this.
    So, Senator Cornyn and I, and I want to thank Senator 
Crapo, who I believe is a cosponsor of the legislation, we have 
introduced the Taxpayer Protection and Responsible Resolution 
Act that addresses this too big to fail and this bailout risk 
head-on. It repeals what I think is a dangerous and subjective 
orderly liquidation authority. It explicitly forbids taxpayer 
bailouts of failing institutions. And it replaces the orderly 
liquidation authority with a transparent, objective, and rule-
based bankruptcy process by reforming the Bankruptcy Code so 
that it is able to handle the resolution of a large, complex 
institution.
    The reforms that we make in our legislation makes the Title 
I resolution of Dodd-Frank, I think, more credible. In my view, 
Title I of the Dodd-Frank Act is not inherently a bad idea, 
since an institution should go through some resolution 
planning. But, it has to be realistic, and that requires a 
Bankruptcy Code that can handle it.
    I think bankruptcy is superior to the orderly liquidation 
authority because creditors and shareholders should shoulder 
the losses if a financial institution fails, not taxpayers. 
Bankruptcy is transparent. It is a rule based process. And, it 
minimizes the risk of a creditor run in times of uncertainty. 
It is superior to OLA, also, because it maximizes the value of 
an estate by allowing either liquidation or a reorganization. 
And, as we have contemplated the change in bankruptcy, it would 
allow for a bridge bank to ensure that you would not have 
systemic risks in the event of such a failure.
    So, today, we are fortunate we will be hearing from some of 
the world's leading experts on this question of how best to 
resolve a large, complex financial firm. Again, I want to thank 
the many experts who have helped with input on this 
legislation, the experts who are here today as witnesses. I 
look forward to their testimony and the question and answer 
period at the end.
    At this time, I will recognize Senator Merkley for his 
opening statement.

               STATEMENT OF SENATOR JEFF MERKLEY

    Senator Merkley. Thank you very much, Mr. Chairman, and I 
also thank the witnesses for bringing their expertise and 
perspectives to bear on this issue, the role of bankruptcy and 
the issue of too big to fail.
    I will be particularly interested to hear what the 
testimony is in regard to the proposal that Senator Toomey and 
Senator Cornyn have put together and how effective the 
Bankruptcy Code would be in resolving large and complex 
financial institutions without the orderly liquidation 
authority granted to regulators in Title II of the Wall Street 
Reform bill.
    While reforming the Bankruptcy Code may prove to be useful, 
I am not sure that bankruptcy alone will be enough to 
successfully resolve the complex, interconnected financial 
institutions without disrupting financial stability and the 
global economy, and certainly that was the purpose of Title II, 
which was put together on a bipartisan basis with a major role 
by Senators Corker and Warner.
    And, of course, the interesting conundrum here is that the 
whole goal is to end too big to fail, and as Senator Toomey has 
presented, that is also his goal and bringing a different 
perspective to bear, and so your insights will be very 
beneficial.
    In 2008, before Wall Street Reform and Title II, Lehman 
Brothers filed for bankruptcy. Here we are in 2015 and they are 
still in bankruptcy proceedings and they are struggling through 
the complexities of a large interconnected investment bank, and 
their demise did, indeed, have an impact on the broader 
economy. So, it is just a small lens on the challenge that 
Title II was seeking to address.
    So, as we wrestle with this, we here as policymakers do not 
spend our entire life on a single topic. You all bring intense 
expertise to bear, and I welcome hearing those insights.
    Thank you very much.
    Chairman Toomey. Thank you, Senator Merkley.
    The vote has been called, so at this time, the Subcommittee 
will recess and we will resume our work as soon as we are able 
to get back from the votes.
    [Recess.]
    Chairman Toomey. The Committee will come to order.
    Again, my apologies for this delay. Senator Merkley is on 
his way back, but he has indicated that we should get started, 
and given the patience that our witnesses have already 
exhibited, I would like to do that.
    So, let me first extend a warm welcome to our panel of 
distinguished witnesses. Mr. Randall Guynn is a partner at 
Davis Polk & Wardell, LLP; Professor John B. Taylor from the 
Hoover Institution Senior Fellow in Economics at Stanford 
University; Professor Thomas H. Jackson, President Emeritus, 
University of Rochester; and Professor Simon Johnson, the 
Ronald A. Kurtz Professor of Entrepreneurship at MIT Sloan 
School of Management.
    Each of you will be recognized for 5 minutes to give an 
oral summary of your testimony. Your full written testimony 
will appear in the record.
    Mr. Guynn, please proceed.

 STATEMENT OF RANDALL D. GUYNN, PARTNER, DAVIS POLK & WARDELL, 
                              LLP

    Mr. Guynn. Chairman Toomey, Ranking Member Merkley, and 
Members of the Subcommittee, thank you for the opportunity to 
testify at this important hearing.
    During the past few years, I have spent a significant 
portion of my time working on resolution plans for a number of 
U.S. and foreign banking organizations under Title I of the 
Dodd-Frank Act. I believe that virtually all of the most 
systemically important banking groups in the U.S. with global 
operations, known as U.S. G-SIBs, are now safe to fail under 
the single point of entry recapitalization strategy known as 
SPoE, for single point of entry.
    I have included a step-by-step illustration of SPoE in my 
written statement. Essentially, it means that only the top tier 
parent of a U.S. banking group is placed into a Title II 
receivership or a bankruptcy proceeding. The operating 
subsidiaries remain open and operating and their losses are 
effectively pushed up to the parent.
    The SPoE strategy was invented by the FDIC under Title II, 
but my colleagues and I quickly realized that it could work 
under the existing Bankruptcy Code if three conditions were 
met. First, the top tier parent must have enough usable TLAC, 
which is defined as the sum of the parent's regulatory capital 
and long-term unsecured debt. To be usable, however, the 
parent's TLAC must be structured so that it is legally 
subordinate to the group's short-term debt. The purpose of this 
structuring is so that all the group's losses can be imposed on 
its TLAC investors before any losses are imposed on its short-
term debt. This will allow losses to be imposed on the private 
sector without causing the deposits and other short-term debt 
to run, which is what can threaten financial stability and 
result in bailouts.
    I understand that all six of the U.S. G-SIBs that relied on 
the SPoE strategy in their 2015 resolution plans now have, on 
average, usable TLAC equal to 25 percent of their risk-weighted 
assets, which is five times the amount of usable TLAC they had 
on the eve of the 2008 financial crisis, as shown in Exhibit F 
of my written testimony. This should be enough usable TLAC to 
recapitalize all of them at full Basel III capital levels if 
they fail under conditions twice as severe as the 2008 
financial crisis.
    Second, the group must have access to a secured liquidity 
facility, such as the Fed's discount window, or enough 
liquidity on its balance sheet to self-insure against liquidity 
risk throughout the SPoE process. I understand that all six of 
the U.S. G-SIBs that relied on SPoE in their 2015 plans now 
have enough liquidity on their balance sheets to execute SPoE 
in a severely adverse economic scenario without accessing 
Government liquidity support. Indeed, they have been forced to 
be so liquid that it is substantially reducing the amount of 
credit they can supply to the market.
    Third, the group must eliminate most cross-defaults in its 
derivative contracts that would allow counterparties to drain 
liquidity out of the group the way they did in Lehman based on 
the parent's bankruptcy when the rest of the group is still 
open and operating and performing on those contracts. Most of 
the U.S. G-SIBs have agreed to adhere to a new international 
agreement called the ISDA Protocol. Under that protocol, 18 of 
the largest counterparties have agreed to waive their cross-
defaults in their ISDA contracts with each other. While the 
regulators are in the process of expanding the ISDA protocol to 
cover a wider range of financial contracts and counterparties, 
the Federal Reserve has characterized the ISDA Protocol as a 
major accomplishment in making the U.S. G-SIBs safe to fail.
    As you know, Title II of Dodd-Frank can only be lawfully 
invoked if the Bankruptcy Code is not up to the task of 
resolving an institution. While I believe that SPoE can be done 
under the existing Bankruptcy Code, I think there is room for 
improvement. I believe that even the FDIC would agree that we 
should try to improve the Bankruptcy Code so that the 
circumstances that allow Title II to be lawfully invoked are 
reduced to the bare minimum. In my view, a sufficient reason 
for doing so is that the Bankruptcy Code is more consistent 
with the rule of law and more predictable than Title II. Adding 
a new Chapter 14 to the Bankruptcy Code along the lines of the 
proposed Taxpayer Protection and Responsible Resolution Act 
should achieve that goal.
    I welcome any questions that any Members of the 
Subcommittee might have. Thank you.
    Chairman Toomey. Thank you, Mr. Guynn.
    Professor Taylor, please proceed.

 STATEMENT OF JOHN B. TAYLOR, HOOVER INSTITUTION SENIOR FELLOW 
               IN ECONOMICS, STANFORD UNIVERSITY

    Mr. Taylor. Thank you, Chairman Toomey, Ranking Member 
Merkley, for inviting me to testify here.
    I think bankruptcy reform is essential to addressing the 
problem of too big to fail. A reform that handles large 
financial firms and makes failure feasible under clear rules 
without spillovers would greatly reduce the probability of 
Government bailouts.
    As you know, much work has been devoted to this issue in 
the last few years, and I think good reform bills have been 
introduced, including the Taxpayer Protection and Responsible 
Resolution Act, but also the Financial Institutions Bankruptcy 
Act of 2015 in the House.
    Chapter 11, of course, has many benefits, including its 
basic reliance on the rule of law. But for large, complex 
financial institutions, it has shortcomings. The existing 
bankruptcy process may be too slow. Bankruptcy judges may not 
have enough financial experience. But perhaps most importantly 
with Chapter 11, it is difficult to both operate a failing 
financial institution and stop runs.
    To deal with these shortcomings, a new chapter is needed, 
like Chapter 14 in the Taxpayer Protection and Responsible 
Resolution Act. Such a reform would use the rule of law and 
shift priority rules of bankruptcy. However, proceedings would 
have Article III judges and special masters. And Chapter 14 
could operate much faster, ideally over a weekend, and leave 
operating subsidiaries outside of the bankruptcy entirely.
    It would do this, as you know, by moving the original 
financial firm's operations to a new bridge company that is not 
in bankruptcy. This bridge company would be recapitalized by 
leaving behind long-term unsecured debt. The aim, of course, is 
to let a failing firm go into bankruptcy in a predictable, 
rules-based manner without spillovers while people continue to 
use its financial services, just as people flew on American 
Airlines planes, bought Kmart sundries, and tried on Hartmarx 
suits during the bankruptcies of those companies.
    To understand how this would work in practice to resolve a 
large financial institution, our research at the Hoover 
Institution at Stanford has looked into how it would have 
worked in the case of Lehman Brothers in 2008, and work by 
Emily Kapur, a summary of which I have attached to my 
testimony, is very illustrative for getting a sense of how this 
new proposal would work in practice.
    In my views, Chapter 14 would work much better than Title 
II of Dodd-Frank. In the case of Title II, the FDIC would have 
to exercise considerable discretion, and I think in some cases 
the uncertainty might be so severe that it will lead 
policymakers to large bailouts anyway. Even if the Title II 
process were used, bailouts would be likely, as the FDIC might 
wish to hold some creditors harmless in order to prevent 
spillovers. The perverse effects of these kinds of bailouts 
occur whether or not the extra payment comes from the Treasury, 
financed by taxpayers, or from a fund, financed by financial 
institutions, or even from smaller payments to other creditors.
    Moreover, under Title II, the FDIC and its bridge bank 
would make the decisions. In contrast, under bankruptcy 
reorganization, private parties motivated and incentivized by 
profit and loss considerations would make the key decisions 
about the direction of the firm, of course, perhaps, subject to 
Bankruptcy Court oversight.
    I think another advantage of Chapter 14 reform is that it 
would facilitate greatly the resolution process now under Dodd-
Frank. As you know, those resolution plans submitted by the 
large financial firms have been rejected by the Fed and the 
FDIC, but with Chapter 14, I think they would be feasible and 
have a much better chance of passing the law.
    So, in sum, Mr. Chairman, Mr. Ranking Member Merkley, I 
think reform of the bankruptcy law is essential for ending 
Government bailouts. If it is accompanied by an increase in 
capital and capital structured debt, such a reform would go a 
long way to ending the too-big-to-fail problem.
    Thank you very much.
    Chairman Toomey. Thank you, Professor Taylor.
    Professor Jackson, please proceed.

STATEMENT OF THOMAS H. JACKSON, PRESIDENT EMERITUS, UNIVERSITY 
                          OF ROCHESTER

    Mr. Jackson. Good morning, Chairman Toomey, Ranking Member 
Merkley, and other Members of the Subcommittee. It is an honor 
to have the opportunity to testify before you on a subject near 
and dear to my heart, the title, ``The Role of Bankruptcy 
Reform in Addressing Too Big to Fail''.
    Specifically, I would like to focus my comments on the role 
bankruptcy law can and should play in the best possible 
resolution of a troubled financial institution and how modest 
but important amendments to the Bankruptcy Code can facilitate 
that outcome.
    First, what do I mean by the best possible resolution of a 
troubled financial institution? I mean a resolution process 
that meets four important tests. First, one that both minimizes 
losses and places them on appropriate pre-identified parties. 
Second, one that minimizes systemic consequences. Third, one 
that does not result in a Government bailout. And, fourth, one 
that is predictable in a sense of conforming to the rule of law 
in the myriad decisions that are made.
    The central role envisioned for bankruptcy law in Dodd-
Frank is reflected in two places. First, it is embodied in the 
notion of resolution plans or living wills. Under Title I, they 
are specifically to be focused on and tested against a 
bankruptcy resolution process.
    Second, it is also reflected in the statutory requirements 
for implementing an administrative resolution proceeding, the 
orderly liquidation authority under Title II. Such a resolution 
proceeding cannot be commenced without a finding that the use 
of bankruptcy law would have a serious adverse effect on U.S. 
financial stability.
    But, I think there is a disconnect between these premises 
and today's Bankruptcy Code. There is an emerging consensus 
that the best resolution system, one that meets the first three 
standards I noted above, involves a debt-based loss-bearing 
capacity known in advance that can be jettisoned in a rapid 
recapitalization of a financial institution. In the U.S., this 
system is represented by the FDIC's single point of entry 
proposal for the recapitalization of a financial institution 
holding company.
    But, even with required loss-bearing capacity, when 
compared to the FDIC's current proposal, the current Bankruptcy 
Code, in my view, is what we would say, close but no cigar. 
Yes, Chapter 11 of the Bankruptcy Code is increasingly used to 
effectuate a going concern sale of a business, sometimes 
rapidly through a prepackaged plan, but it will struggle to do 
this in the case of a financial institution.
    The essence of a recapitalization is leaving behind equity 
and the loss-bearing debt to bear the losses and the transfer 
of everything else--assets, liabilities, rights, licenses, and 
subsidiaries--to a bridge company that, because of the 
stripping off of the loss-bearing debt, is presumably both 
solvent and in a position to deal with the needs of its 
subsidiaries, and this must be done with great speed so as to 
restore market confidence without a contagion-producing run.
    The current Bankruptcy Code, I believe, cannot provide the 
necessary assurance of a rapid recapitalization of this sort. 
Even with the announcement of a new protocol by the 
International Swaps and Derivatives Association that ends the 
ability to immediately terminate qualified financial contracts 
in a resolution proceeding, the problem remains, it currently 
only applies to the 18 largest global financial institutions 
and it does not deal with change of control provisions and 
licenses or other nonexecutory contracts.
    Nor is it certain to me that a judge under the current 
Bankruptcy Code would feel comfortable even with a resolution 
plan authorizing the transfer and, hence, recapitalization in a 
period such as 48 hours without clear statutory authorization. 
This will lead, in my view, either to ineffective resolution 
plans and/or the reality that OLA under Title II will, contrary 
to expressed desires, become the default resolution mechanism.
    What is required in addition to specified debt-based loss 
absorbency capacity known in advance that is being addressed 
separately, it requires explicit statutory authorization for a 
rapid 48-hour transfer of a holding company's assets, 
liabilities, rights, and subsidiaries minus loss-absorbing debt 
and equity to a bridge institution and stays and overrides of 
provisions to allow that to happen.
    The Taxpayer Protection and Responsible Resolution Act 
provides the core changes to the Bankruptcy Code to make it a 
credible resolution mechanism, as does the House bill enacted 
last session. Both neatly provide the necessary amendments to 
bankruptcy law to permit this rapid recapitalization. Think of 
it as taking the structure that is there of the going concern's 
sale under Section 363 of the Bankruptcy Code and putting it on 
the necessary steroids to deal with a large financial 
institution.
    While there can be robust debates on several choices made, 
as I illustrate in my written statement, these minor 
disagreements should, in my view, not hold back the 
consideration or enactment of these bankruptcy provisions, nor 
should non-bankruptcy-related considerations. We need these 
amendments to the Bankruptcy Code.
    And, again, I would like to thank the Subcommittee for 
allowing me this opportunity to express my views. And, of 
course, I would be delighted to take questions.
    Chairman Toomey. Thank you, Professor Jackson.
    Professor Johnson.

   STATEMENT OF SIMON JOHNSON, RONALD A. KURTZ PROFESSOR OF 
        ENTREPRENEURSHIP, MIT SLOAN SCHOOL OF MANAGEMENT

    Mr. Johnson. Thank you, Senator, and thank you for holding 
a hearing on such an important and timely topic.
    I would like to make three points. First, I think all 
companies in the United States should be able to go bankrupt. I 
think you could regard it as a right of American corporations. 
I do not understand why some companies should have access to a 
different Bankruptcy Code than other companies. If you are 
going to change the code, and I am completely open to that, I 
think it should be available to all companies on an absolutely 
equal footing.
    If we start to say some companies have different access, 
some companies can get different kinds of protection from their 
creditors, surely, we open again the question of is that better 
or worse, and if it is better, if I am getting some additional 
protection from my creditors, do I not want to be in that 
category, and you have just created a version of ``too big to 
something'' that you said you were trying to avoid.
    The essence of the various bankruptcy proposals that we 
have before us in the public debate, all of which are, 
obviously, very well thought through and extremely detailed, I 
think it really comes down to this, Senator, which is are we 
providing debtor-in-possession financing from the public sector 
in some form to a bankruptcy court or not? If we are not, then 
the private sector has to provide the funding, which they will 
not. That is why it is called a crisis. The idea that we can 
rely on these companies to always have enough liquidity on 
their balance sheet to avoid this issue, I think, is 
unrealistic. Again, that is why it is a crisis, because they 
run out of liquidity.
    Now, if the Government is providing debtor-in-possession 
financing, that is a different ballgame altogether. But, I have 
a lot of concerns about that, Senators, as I think you must. 
So, if, let us say, we come to a point where the Treasury--it 
would be the Treasury, not the Fed, I believe--is providing a 
loan of $10, $20, $50 billion to a bankruptcy court, what is 
the political legitimacy of that? What is the economic 
expertise and management skills being brought to bear on that 
by the bankruptcy judge or whatever trustees they put into 
place? I think the backlash, justifiable backlash you would get 
against that would be enormous, and I really do not think that 
is a good idea from the economic point of view.
    Now, if we agree that some large financial firms would have 
trouble going bankrupt, or if they went bankruptcy under the 
current code we would risk re-running a version of the Lehman 
scenario, I think there are actually two routes forward. One is 
to try and change the code selectively for those firms, and I 
am very worried about that. The other is to change the firms, 
and as I think we agree--certainly the witnesses seem to be 
agreeing--under Dodd-Frank, the presumption is that all firms 
would be able to go bankruptcy and Title II is there as a 
backup, last resort, just in case the regulators got it wrong 
in the living will planning process and find at the very last 
moment, as they did in the Lehman weekend, for example, after 
the Barclays deal fell apart, they find that the consequences, 
or they begin to think the consequence of that bankruptcy could 
be cataclysmic for the system.
    Now, where, exactly, is the pressure point going to be and 
how does it compare with current structures? I think it is 
pretty obvious, and again, we saw it in the Lehman case. It is 
global. It is cross-border.
    For example, the FDIC--and I think the living wills process 
and the resolution planning process has been helpful. It has 
revealed a lot of details that are very useful, including the 
following. The FDIC has a Memorandum of Understanding with the 
Bank of England on how they would cooperate in the event of 
resolution. That cooperation would not apply if we were 
following Title I bankruptcy.
    The global nature of these firms really matters. If Lehman 
or any other firm today were put into bankruptcy, the U.K. and 
other regulators around the world would immediately move to 
seize assets, just as they did in September 2008. Now, that is 
extremely not helpful. You are not going to change that by 
amending the U.S. Bankruptcy Code. You would need a treaty 
between countries to cooperate in the event of bankruptcy, and 
I really do not think you are going to get a treaty. You need 
to change the global nature of these businesses and/or make 
them considerably smaller, firewall them off international.
    The TLAC, the total loss absorbing capacity that we have 
started to talk about, is a complete illusion, Senator. There 
is no such thing as loss absorbing debt. When the debt goes 
down, you find the person who was holding that contingent debt 
did not fully understand the risk. You find they were highly 
leveraged. You find they were an insurance company. You find 
they were an AIG. You find that they were held by money market 
funds. It is September 2008. Again, you need equity. You need a 
lot of loss absorbing equity on the balance sheet at the 
holding company level of all these global companies.
    We have inched toward reasonable equity levels measured on 
that basis. We have not made much progress. The amount of 
equity on the balance sheet of our largest banks is between 4 
and 5 percent measured on a leverage basis. That means 95 to 96 
percent debt, 4 to 5 percent equity. And they gamble massively 
in the global markets every day. That is the point on which we 
should be focusing, and that is how you address the bankruptcy 
issues, as well.
    Thank you.
    Chairman Toomey. Thank you, Professor Johnson.
    Well, let me just start--let me just follow up on this, and 
maybe this will give an opportunity for Mr. Guynn to respond to 
something that Mr. Johnson said, because, Mr. Guynn, you 
indicated in your testimony that one of the essential features 
of having a successful resolution of bankruptcy is loss 
absorbing capital, which intuitively makes sense to me, but 
Professor Johnson said, among other things, maybe the creditors 
do not understand the nature of the risk. I find that 
implausible, frankly, but how would you respond to his concern 
that TLAC is not adequate?
    Mr. Guynn. Yes. Well, I obviously disagree with Professor 
Johnson, and I think the FDIC disagrees and so does the 
National Bankruptcy Conference. The fact of the matter is that 
if you convert debt to equity in a bankruptcy proceeding, it is 
loss absorbing just like equity. There is no difference between 
the two. And, it does not matter whether you do that through a 
direct bail-in or a bridge bail-in--what I think Professor 
Jackson refers to as a one-entity or a two-entity 
recapitalization. The single point of entry method using a 
bridge financial company is a two-entity recapitalization, 
where you basically transfer all of the assets of the failed 
company to the bridge and you leave behind in a receivership or 
bankruptcy its long-term debt. The debt gets converted to 
equity in that new company. So, it is loss absorbing and I do 
not know why Professor Johnson says otherwise.
    Chairman Toomey. Let me move on to another issue here, and 
this is for Professors Taylor and Jackson. Do you think it is 
fair to say that the nature of the orderly liquidation 
authority as it exists now, together with the Bankruptcy Code 
as it exists now, actually could increase the risk of a failure 
in the event that there were some volatility, disruption, 
problems in the markets?
    Mr. Taylor. Well, I think, currently, the first part of 
Dodd-Frank Title I, where the living wills are submitted and 
approved, that is not working, and I think the problem is the 
existing Bankruptcy Code. So, a revision of that would help. I 
think it is very important for that purpose alone.
    I also, as I indicated in my testimony, am concerned about 
Title II's operations of high degree of discretion given to the 
FDIC, the uncertainty that might cause, and, therefore, the 
possibility of additional uncertainty and risk from that. So, I 
would agree that there is a problem with that, as well.
    Chairman Toomey. Professor Jackson.
    Mr. Jackson. I am not sure I would think it increases the 
likelihood of a failure. I think what you would have now----
    Chairman Toomey. And could I just interrupt for a second--
--
    Mr. Jackson. Yes.
    Chairman Toomey. ----just because an increase begs the 
question of relative to what, and I mean relative to a 
bankruptcy mechanism that works.
    Mr. Jackson. Yes. I think it does in the following way, or 
at least it pushes everybody to Title II OLA resolution 
proceedings, which is expressly contrary to the express desire 
even in Dodd-Frank for Title II itself, because currently, even 
with the ISDA Protocol, for most of these financial 
institutions, Title II stays the derivative contracts for the 
period necessary to enter the bridge company. A bankruptcy has 
exemptions from the automatic stay for qualified financial 
contracts and is unable to do that. So, it is a big mover away 
from being able to use bankruptcy, and I suspect it is a hang-
up on the resolution plans, which need to show what happens 
under bankruptcy, not under Title II.
    Chairman Toomey. And, Mr. Guynn, the legislation that I 
have introduced with Senator Cornyn, the way I think of it, it 
has got three main changes that it makes to the Bankruptcy 
Code. One is it creates a panel of experienced judges who would 
handle the filing of a bankruptcy. The second is it creates 
these temporary 48-hour stays on derivative instruments in 
particular, but some others. And then, of course, it creates 
the bridge company, which is similar to what is contemplated in 
OLA.
    In your view, are each of these three items important 
reforms to bankruptcy, and would you just care to comment on 
them.
    Mr. Guynn. Sure. I think all three of them are actually 
very useful reforms. Obviously, having a set of bankruptcy 
judges or Article III judges who have experience, or view it as 
their mandate to develop expertise, about financial institution 
failures is a good thing. It is going to work better.
    As far as having a stay for 48 hours, that is a also good 
idea. Most derivatives contracts are actually booked at the 
operating subsidiary level, so you tend not to have a 
termination of those contracts under SPoE unless the contracts 
contain cross defaults to the parent's failure. There are very 
few derivatives at the parent level and they tend to be inter-
company, so they typically will not be terminated. But, having 
a 48-hour stay is very useful, and in particular, your bill 
also would override cross-defaults, which is actually very 
useful. Otherwise, you have to rely on something like the ISDA 
Protocol, which I discussed earlier.
    The last one--I have forgotten the last thing you 
mentioned----
    Chairman Toomey. The bridge company.
    Mr. Guynn. Oh, the bridge company. This is helpful, and 
also, I think, combined with the express authority to be able 
to transfer quickly the assets to a bridge. I think that 
convincing bankruptcy judges they have the authority do a quick 
transfer to a bridge is probably the biggest challenge under 
the current Bankruptcy Code. It can be done, we believe it will 
work, but it will require education of bankruptcy judges 
themselves to say, yes, you have this authority. The bankruptcy 
judge did a quick sale in Lehman within 4 days. You are not 
actually doing a sale here. You are just moving the ongoing 
operations into a bridge company that will be held for the 
benefit of the bankruptcy estate. Nevertheless, having the 
legal authority clearly spelled out in a statute will eliminate 
the legal uncertainty as to the authority of the judge to do 
it.
    Chairman Toomey. Thank you, Mr. Guynn.
    Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chairman, and 
thank you all for your presentations.
    Professor Taylor, you mentioned that you do not believe the 
living wills are working, but I just want to check in. In terms 
of Title I living will, the concept behind it, my impression is 
that all of you support that work being done, is that correct?
    Mr. Taylor. Yes, I support that.
    Senator Merkley. And, Mr. Taylor, or Professor Taylor, are 
there a couple things that, specifically, you would like to see 
done to improve the working of those living wills?
    Mr. Taylor. I think, in particular, if there was a--
something like Chapter 14 or something like the proposed bill 
here, it would make it feasible for the companies to submit the 
resolution plans, living wills, that are consistent with a 
bankruptcy without Government bailout. It is now very difficult 
to do that. The whole idea of having an operation that is in 
bankruptcy and preventing it from running under existing law is 
hard, and so they say, well, we need some help. We need some 
extra support. So, there is that inconsistency. So, Chapter 14, 
I think, resolves that, because you can operate the 
institution. Its businesses will still be operating through 
this bridge company.
    Senator Merkley. Thank you.
    And, Professor Johnson, any insight on that particular 
piece of the puzzle?
    Mr. Johnson. Yes, Senator. I think the Dodd-Frank intention 
is pretty clear and consistent, actually, which is given the 
existing code, which was not modified as part of Dodd-Frank 
along this dimension, the banks have to show that they are able 
to be resolved through bankruptcy without causing large 
systemic risks, which, I agree, means that most likely they 
would have to be liquidated or wound down, and the fact that we 
are having this conversation tells you that many people out 
there in the business community are very concerned about the 
systemic implication of such a wind-down, which means, 
according to the logic of Dodd-Frank, if you are not going to 
amend it, that the regulators should be moving to make these 
banks much safer, presumably smaller, presumably simpler, and 
much easier to unwind through liquidation.
    Senator Merkley. Thank you.
    I want to turn to the orderly liquidation fund, which I 
think is part of the point that the Chairman is making, 
concerned that that turns into a taxpayer-funded bailout. I 
wanted to check in on that point with all of you. The OLF line 
of credit available through the FDIC was envisioned to enable 
the FDIC to provide fully secured loans at above-market rates 
to sufficiently capitalized or recapitalized firms, and thus 
the lender of last resort facility. And, losses--under that 
OLF, the losses are imposed on the shareholders, long-term 
unsecured debt holders, the holders of other liabilities, but 
not on taxpayers. And, the FDIC would have to proceed to cover 
those costs either through the assets of the failed company or 
eventually post hoc assessments on surviving financial 
institutions.
    Now, I believe Mr. Guynn and Professor Jackson, that you 
all were two of the principal authors of a report that 
addressed this, and if I understood it correctly, I thought 
that that made some sense. But, I wanted to ask you all about 
that now.
    Mr. Guynn. Yes. Thank you. So, the standards that you 
actually recited are the classic standards that Bagehot set out 
more than a century ago for central bank lender of last resort 
liquidity, and the FDIC has announced that it would use the 
orderly liquidation fund according to those standards. The 
statute itself does not actually bind them to that. So, that is 
why, to the extent people sometimes criticize the OLF, it is 
because those standards are not embedded in the statute. But, 
the FDIC has said that that is how it would use the OLF, and so 
that is the appropriate way to use it.
    Senator Merkley. So, with that caveat, it makes sense to 
you?
    Mr. Guynn. Yes.
    Senator Merkley. OK. And Professor Jackson.
    Mr. Jackson. Yes. I think that one of the great advantages 
of single point of entry, either under Title II or under the 
Chapter 14 procedure, is that the bridge institution--and I 
think it works better in bankruptcy because it is not under the 
supervision of the FDIC--is a company that is recapitalized, 
should look immediately solvent to the market participants, and 
generally should be able to get its own liquidity in a vast 
variety of circumstances.
    There may be some, such as a liquidity freeze across 
institutions, a little bit like happened in 2008, 2009, where 
that will not be possible, and in those cases, it seems to me, 
and now speaking about bankruptcy specifically, the Federal 
Reserve Board's ability to lend to institutions where there has 
been a multiple industry problem strikes me as a solid back-up 
that would not need to be changed.
    Senator Merkley. Thank you.
    Professor Johnson.
    Mr. Johnson. Senator, I used to be the Chief Economist at 
the International Monetary Fund and I worked on a lot of crises 
over the past 30 years. There is never liquidity in the market. 
That is why it is a crisis. And, the financing terms of this 
fund would be absolutely critical.
    I do agree that the FDIC has drawn up some sensible rules. 
I do not think that this bankruptcy scenario would work at all 
in terms of avoiding systemic risk unless there is some sort of 
additional Government-provided financing, and I do not think 
you want to provide that kind of Government financing to a 
bankruptcy corp.
    Senator Merkley. Thank you.
    Chairman Toomey. Senator Warren.
    Senator Warren. Thank you, Mr. Chairman. I apologize for 
being late. We are trying to cover three hearings at the same 
time.
    So, let us get to the key point we are talking about here. 
No financial institution should be too big to fail, and to me, 
that means three things. If a bank is on the verge of failure, 
we should be capable of shutting it down without bringing down 
the entire financial system. The shutdown should not require a 
dime of taxpayer money. And the shutdown should not create 
moral hazard by letting the bank's executives escape 
accountability.
    Now, the Chairman recently introduced a bill that creates a 
new process for liquidating our biggest financial institutions 
and repeals the existing process found in Title II of Dodd-
Frank, and I appreciate the Chairman's efforts, but I am 
concerned that his proposal creates more problems with each of 
the three standards that I just laid out.
    The Chairman's bill does not create any established source 
of short-term liquidity, the point we were just talking about 
here, for any failing institution, instead relying on the 
market to provide funding for that failing institution.
    So, just so we have got the record clear on this, Professor 
Johnson, let me ask you, is it realistic to expect the market 
to provide short-term liquidity for a failing institution in a 
time of crisis?
    Mr. Johnson. No, that would not be a realistic expectation.
    Senator Warren. All right. And, in fact, I thought I heard 
you say, Professor Jackson, the answer is, let the Fed bail 
them out if it is a short-term liquidity crisis.
    Mr. Jackson. No. My--the failed institution--one of the 
great advantages, I think, of the bridge company is it 
immediately transfers a failed institution into two different 
entities, an entity that has----
    Senator Warren. I understand that----
    Mr. Jackson. OK.
    Senator Warren. ----Professor Jackson. I understand how 
this works. I just listened to your testimony just now and you 
said, gee, if we had a crisis like 2008 and liquidity dried up, 
as Professor Johnson said it most likely will in this kind of 
circumstances----
    Mr. Jackson. But it would be under----
    Senator Warren. ----it would say, let the Fed take care of 
it.
    Mr. Jackson. It would be under the circumstances where it 
was not directed at the particular institution but to a broader 
liquidity problem.
    Senator Warren. But----
    Mr. Jackson. And, I----
    Senator Warren. But you are talking about putting taxpayer 
dollars in, and to me, that is what too big to fail is all 
about.
    Mr. Jackson. Taxpayer dollars into an industrywide issue 
that would not distinguish between the institution that was in 
the resolution proceedings and the ones that were not.
    Senator Warren. So, in other words--let me just wrap this 
back around. Professor Johnson, would not the Chairman's bill 
just put us back where we were in the 2008 crisis so that 
Congress would either have to step up with a taxpayer bailout 
or risk the entire meltdown of the financial services industry 
and potentially the economy?
    Mr. Johnson. Yes. I fear you would have another Hank 
Paulson-Ben Bernanke moment when they come to you and say, if 
you do not give us a large amount of money with few strings, 
there will be a global cataclysm.
    Senator Warren. Well, and I think that is what we are all 
trying to avoid here.
    You know, there is one other part to this that I want to 
talk about, besides the fact that the Government should not 
be--the taxpayers should not be put in the position of having 
to choose between either watching the economy implode or having 
to bail out these big financial institutions, and that is the 
question of moral hazard built into this.
    The Chairman's bill lets the CEO and the management team of 
the bank keep their jobs and all of their past compensation. 
That is the same sweet deal that the bankers got in 2008. So, 
Professor Johnson, let me ask, do you believe that the 
Chairman's bill does enough to discourage senior management 
from taking on big risks that threaten the entire financial 
system?
    Mr. Johnson. I think, Senator, that it does not do enough. 
I think that was a major issue in the run-up to 2007 and I fear 
it could absolutely happen again.
    Senator Warren. All right. Thank you.
    I know this is a complicated issue and I appreciate the 
Chairman's contribution to this conversation, but I have 
serious concerns about any proposal that would once again force 
Congress to face another bailout decision and would once again 
let CEOs get all of the upside of taking big risks but none of 
the downside on this. I think we need more accountability in 
the system, not less.
    Thank you, Mr. Chairman.
    Chairman Toomey. Thank you.
    So, to begin the second round, let me just ask a question. 
If a car company or an airline goes into bankruptcy, does the 
Bankruptcy Code force the senior executives all to be fired as 
a result of that? Professor Jackson.
    Mr. Jackson. No.
    Chairman Toomey. No. But, I guess some believe that the 
financial institution should be uniquely subject to that.
    Let me ask this question. Dodd-Frank as written 
specifically says that the default setting for a resolution 
should be bankruptcy. Professor Taylor, do you think right now, 
as a practical matter, the market believes that the default 
setting for the failure of a big financial institution would be 
bankruptcy, or----
    Mr. Taylor. No, I do not believe so, Mr. Chairman. I think 
that is the purpose of the proposal you have, Chapter 14, 
whatever you call it. It is to allow that to happen, to have a 
bankruptcy in a credible way.
    Chairman Toomey. But, the point is that right now, that is 
not perceived to be a credible alternative.
    Mr. Taylor. That is correct.
    Chairman Toomey. Despite the fact that Dodd-Frank 
contemplates that that should be the preferred path.
    You say in your testimony, Mr. Taylor, that under Title II, 
it would likely--that the confusion of how a firm would be 
reorganized would likely lead policymakers to ignore the 
orderly liquidation authority in the heat of a crisis and 
resort to massive taxpayer bailouts as in the past. So, as I 
understand it, you are saying that the current structure that 
we have very much contemplates, or it would very much resort to 
this taxpayer bailout. Could you elaborate on that a little 
bit.
    Mr. Taylor. Well, that is a real concern with the Title II 
and the orderly liquidation authority, the resolution process. 
The FDIC would effectively have discretion about which 
creditors benefit, which do not. It would not necessarily use 
the priority scheme of bankruptcy, which is very clear in the 
law. I think that uncertainty would make people nervous, and a 
policymaker in a very responsible position would, quite 
frankly, I think, be tempted to go through a bailout like we 
saw before in 2008. So, I am concerned about that.
    Chairman Toomey. And, the last question for Professor 
Taylor, I think, if I understood the Senator from Massachusetts 
articulate three concerns about what ought to happen in the 
event of a failure, one would be the possibility of shutting 
down the institution, one would be not costing taxpayer money, 
and the third would be firing the executives. But, then my 
legislation was criticized for not, I think, for not having the 
Government providing any financing facility, debtor-in-
possession facility, which seems to me to be the exact 
mechanism that would put taxpayers at risk. Is that your view, 
Mr. Taylor?
    Mr. Taylor. Yes. I think the importance of a bankruptcy 
concept is the people who are holding this debt are the ones 
that are going to suffer. They are at risk. And, if there is a 
sufficient amount, and Mr. Guynn indicated, that will resolve 
this operation. It is important to get a sufficient amount, to 
be sure. But, they will suffer the losses. That deals with the 
moral hazard issue. That has a much better sense of risk taking 
and it does put people at risk if the Government goes through 
with a proposal like this.
    Chairman Toomey. So, Mr. Guynn, it seems to me that--one of 
the things that I have been concerned about for a long time is 
that regulators have generally, and I am reluctant to paint 
with too broad a brush here, but I do perceive a sense on the 
part of many regulators that their job is to make it impossible 
for a financial institution to fail, which might suggest that 
they do not have a great deal of confidence in the current 
resolution mechanism. But, whether or not that is their 
motivation, is there a danger, in your view, that could result 
from over-regulation in the attempt by regulators to make it 
impossible for an institution to fail, and if so, what is the 
downside of over-regulation?
    Mr. Guynn. Well, obviously, over-regulation can be a drag 
on the banking system, which will then be a drag on lending and 
a drag on the broader economy. I actually think that the banks 
have a lot more liquidity and capital and loss absorbing 
capacity than they have had before. So, it is very different 
from 2008. In fact, in my written testimony, I have an exhibit 
that shows that they actually have five times the amount of 
cash and high-quality liquid assets now than they had in 2008.
    And, I actually think that it is possible for banks to have 
too much liquidity. In fact, I mean, Governor Tarullo gave a 
great speech on this subject last November, where he talked 
about two extremes: banks being required to self-insure against 
liquidity risk, even in a failure situation under an SPoE, and 
he also talked about the other extreme, where they are over-
reliant on lender of last resort facilities, and suggested that 
there needed to be a balance between those two.
    The fact of the matter is that the banks currently have 
been forced to become and have become arguably too liquid in 
order to show that the SPoE resolution strategy under the 
Bankruptcy Code is credible. So, the real question is whether 
forcing them to do that is good public policy or not or whether 
there should be more of a balance.
    Chairman Toomey. Thank you.
    Senator Merkley.
    Senator Merkley. Thank you, Mr. Chairman.
    I want to go back to this issue of liquidity at the time of 
crisis. So, we have a major firm that perhaps they are unable 
to provide the funds to complete a 24-hour repurchase 
agreement. There are various other things that are unfolding 
very quickly. They are in crisis. And, the general 
understanding was that if you want--you have three possible 
situations there. They can turn to liquidity to the private 
markets. They can turn to liquidity in something like the OLF, 
where it is--liquidity is ultimately funded by both the company 
assets or an assessment on the banking world. Or, you just 
proceed with a chaotic collapse.
    And, I think the theory was that the chaotic collapse did 
not work very well in 2008. It created a contagion that spread 
from company to company. You had a fire sale on one set of 
assets, Lehman Brothers, that diminished the value of those 
assets held in the other companies, and it was not a pretty 
outcome, and that private liquidity is not going to materialize 
in that situation. They would not be in crisis if they could 
access private liquidity. So, therefore, turning to a 
structured liquidity funded by both ultimately the assets of 
the company and the FDIC assessment would be the most logical 
result.
    And, so, I think at least three of you have supported the 
idea of the OLF within Title II, but I just wanted to, since 
this is kind of at the heart of this discussion as to whether 
this is the most logical path, I just wanted to start and run 
across, have all four of you comment on this. Professor 
Johnson.
    Mr. Johnson. Well, yes, Senator, today, because the living 
wills process has not been followed through. It is a failure of 
implementation of Dodd-Frank. Dodd-Frank absolutely requires, 
and I think that, largely, the discussion shows this, that 
these banks have to become simpler and much easier to resolve 
under the existing Bankruptcy Code and we have not done that. 
So, yes, there is this fallback on the OLA, and I think you are 
right to be uncomfortable. We should not be jumping straight to 
Title II. We have not worked through Title I properly.
    Senator Merkley. OK. So, that taken, we need to do a lot 
more work to implement Title I. But, at this point, would you 
support the repeal of Title II, or is that backstop an 
important one to have?
    Mr. Johnson. You need to backstop, Senator. But, the 
regulators have to understand, and I think it is very helpful 
to have this kind of hearing to make the point to them that it 
is not satisfactory to just fail to follow through on the 
intent of Dodd-Frank and to let the large banks off the hook 
with regard to their resolvability under bankruptcy under the 
existing Bankruptcy Code. Nobody on this panel is saying that 
that is feasible, right.
    Senator Merkley. Right.
    Mr. Johnson. That is a failure of implementation of Dodd-
Frank.
    Senator Merkley. Very good.
    Professor Jackson.
    Mr. Jackson. With respect to the orderly liquidation fund, 
I think the concept is good. I think it has the potential of 
being abused. I do not think it needs to be mirrored or 
replicated in the bankruptcy process where the bridge company 
is not under FDIC authority, should be recognized as solvent. I 
do think, and I think it is distinct from a bailout, it should 
have the same access rights to Fed funds as other institutions 
do at a time of liquidity----
    Senator Merkley. But, you are not arguing at this point for 
a repeal of Title II?
    Mr. Jackson. I actually--I think Title II--I think, one, if 
you do these bankruptcy reforms, you are going to diminish 
enormously the need to rely on Title II, which is explicitly 
part of Dodd-Frank to begin with. That is step one. You will 
get a lot--without repealing it, you will make it actually a 
much less likely scenario.
    Second, I think the world may unfold in uncertain 
circumstances, so I would like to see it there as a backup----
    Senator Merkley. Thank you. Thank you.
    Professor Taylor, keep it as a backup or repeal it?
    Mr. Taylor. Well, I am sorry. With respect to the 2008 
situation, there was so much confusion about how each company 
would be handled, Bear Stearns, Lehman Brothers, AIG. The 
advantage of having something like this reform of the 
Bankruptcy Code is it would, in principle, be a uniform 
treatment for these firms. There is in the law currently a 
backstop, 13(3) of the Fed. I think it needs to be implemented 
in a way that is clear, penalty rate, for example, or the rule 
of how it would be operated----
    Senator Merkley. Because I am running out of time, just get 
to the heart of it. Do you feel that with that additional 
provision that you referred to that we can eliminate Title II, 
or would you keep it as a backstop?
    Mr. Taylor. OK. So, I would really just want to repeat, if 
you like, Professor Jackson on this. I think whether you have 
Title II or not, you need this reform.
    Senator Merkley. OK, that is fine----
    Mr. Taylor. My preference----
    Senator Merkley. ----but that is not the question I am 
asking----
    Mr. Taylor. ----would be not to have Title II and have this 
reform. But, whether you have it or not, this reform is 
essential.
    Senator Merkley. The Chairman is going to cut me off. That 
is why I am asking you to be succinct. But, what Professor 
Jackson said was that changes may make it far less necessary, 
but you should keep it as a backstop, and you are echoing that 
sentiment in your concluding sentence there?
    Mr. Taylor. Actually, I am sorry to take so much time with 
this, but I have written it. Problems with Title II, I think, 
is problems as it exists. I would prefer if it goes. However, 
the reality--if that stays, I would really support so much 
having the Chapter 14 or whatever this bill is. I think it is 
very important to make this whole operation work.
    Senator Merkley. I had so many other questions I was going 
to try to get to. I am not going to make it, so I will just 
complete this panel. Mr. Guynn.
    Mr. Guynn. So, I think even the FDIC would support this 
legislation, making bankruptcy better so that Title II is only 
needed in the smallest number of circumstances. But, I think it 
is useful to retain Title II for at least one reason, and that 
is to preserve cross-border cooperation by foreign regulators. 
The U.S. is almost unique in having a tradition of 
reorganization in bankruptcy. Outside the United States, the 
regulators just do not associate it with bankruptcy. When they 
hear the word bankruptcy, they think liquidation, and so it is 
actually useful to have Title II just so they know that there 
is a backup of something that looks more like their special 
resolution regimes, which they associate with recapitalization 
or reorganization. Ironically, we call Title II the orderly 
liquidation authority. They associate Title II more with 
reorganization or recapitalization regimes.
    Chairman Toomey. Thank you.
    Senator Warren.
    Senator Warren. Thank you, Mr. Chairman.
    So, the Chairman asked the question about why deal with 
moral hazard and suggested that to say that bank executives of 
these large too-big-to-fail banks, if they bring down an entire 
institution, should have some responsibility for that. And, so, 
I just want to ask the question again. When a big construction 
company fails, he asked the question, are the executives fired 
under Chapter 11 and the answer is no. But, does a big 
construction company, if it fails, threaten the entire economy? 
Professor Johnson.
    Mr. Johnson. No, hopefully not----
    Senator Warren. Hopefully not, at least----
    Mr. Johnson. ----not historically.
    Senator Warren. Yes. And, do we see the Secretary of the 
Treasury or the Federal Reserve Chair coming in to tell the 
American people that they need to bail out a big construction 
company?
    Mr. Johnson. No, we have not experienced that.
    Senator Warren. All right. So, I think--and then the 
question is, does that change the calculus on whether or not we 
need to find devices in the law for holding the executives of 
the biggest financial institutions accountable if they threaten 
to wreck the economy again. Professor Johnson.
    Mr. Johnson. I am absolutely in favor of holding them 
accountable, and just to add a small fact to this, the 
corporate executives of the top 14 U.S. financial companies 
made $2.5 billion in compensation between 2000 and 2007. The 
most compensated five of them made $2 billion of that. They 
were the people who took on the risks of all the big companies 
that you know very well, the AIGs, Countrywide, Lehman, Bear 
Stearns. They are the ones who brought down the system. So, the 
moral hazard is front and center of our concerns here.
    Senator Warren. All right. Thank you. Thank you, Professor 
Johnson.
    And, I just want to go to one other point, and that is I 
very much am struck by your point, Professor Taylor, and that 
is that markets do not believe that, if pressed, the United 
States Government would not bail out the too-big-to-fail banks 
right now. I think that was your point, right?
    Someone asked a question, the law right now says that we 
will not. If we pass five laws that say we are never going to 
bail them out, will that change whether or not the markets 
believe that, if pressed, if the economic system is at risk, if 
a too-big-to-fail bank threatens to bring down the entire 
economy, that what will happen is that the American Government 
and the American taxpayer will be put on the hook to bail them 
out?
    Mr. Taylor. Senator, the purpose of this bill, or Chapter 
14----
    Senator Warren. I am not asking you that question.
    Mr. Taylor. Well, that is how I would answer it.
    Senator Warren. Well, what I heard you say is that no one 
believes----
    Mr. Taylor. With the current bankruptcy law.
    Senator Warren. All right. Let me ask it a different way. 
In 2008, did we have a law that said that the Federal 
Government would bail out the biggest financial institutions if 
they threatened to bring down the entire economy?
    Mr. Taylor. No. We had the----
    Senator Warren. No. We had no law on it, right? And yet, 
when faced with the choice of either watching the economy 
collapse or bailing out the biggest financial institutions, 
what did Congress do at that point?
    Mr. Taylor. They bailed them out.
    Senator Warren. They bailed out the biggest financial 
institutions.
    The question for me, and this was the one that the Chairman 
asked--I understand, we are trying to get to the same place. We 
are not at loggerheads over this part of it. The question is, 
realistically, how do you get there. And for me, that is why 
things like the living wills are so important and why they 
intersect powerfully here. It is why regulatory structure is so 
important. It is why Glass-Steagall is so important. The things 
that keep us away from coming to the precipice of banks that 
can bring down the entire economy.
    So, I appreciate the point, and I really do. I am not 
trying to argue with you about where we are trying to get. It 
is just a question of whether or not passing one more law to 
promise, promise, promise we will not bring down the economy 
will change--will not bail out big banks--will change anything 
if we are put in the position of it is either bail out the big 
bank or watch the economy collapse, and that is the part I am 
worried about.
    Mr. Chairman, thank you.
    Chairman Toomey. Well, and I thank the Senator from 
Massachusetts and I appreciate her participation and her 
thoughtfulness on this.
    I would just--it seems there is a pretty clear disagreement 
about one fundamental aspect here. It is my view, and I would 
like to get the input from our witnesses, that the way in which 
to ensure that the market does believe that resolution in a 
bankruptcy is adequate and to ensure that taxpayers are not at 
risk, Professor Johnson has one approach, which is shrink the 
banks. It strikes me that one could view that as the tail 
wagging the dog a little bit, because maybe the cause of the 
problem is the inadequacies of the Bankruptcy Code. And, so, if 
we correct the inadequacies of the Bankruptcy Code and we do it 
in a way that taxpayers are not at risk, then we do not have to 
bother with deciding exactly which line of business on a 
Tuesday a given bank can do as we do now.
    So, I guess my question for Professor Taylor is, is it your 
view that if we made these changes to the Bankruptcy Code, 
which Congress is, of course, entirely free to do if it chose 
to, that the market would believe that the Bankruptcy Code 
would work and, therefore, would be used, and, therefore, we 
would not face this question of must we bail out the banks or 
face a systemic crisis.
    Mr. Taylor. Yes. That is really the whole purpose, in my 
view, is to give--when the policymakers in the future come to 
Congress and ask for a bailout, you say, there is an 
alternative. You have this bill, this Chapter 14, which is the 
way to go through bankruptcy without causing spillovers, 
without causing this damage. And, so, no, we do not need a 
bailout. We will not do that. We have this alternative, which 
is much more credible.
    Chairman Toomey. Now, Mr. Guynn, I think you said earlier 
that you think it is entirely possible that the Bankruptcy Code 
might be adequate as it is currently written, but that it would 
be much better if it had these changes. If it did have these 
changes, is it your view that there would be a broad consensus 
that a failure of a large firm could be safely resolved through 
bankruptcy?
    Mr. Guynn. Yes. But let me answer that by responding to 
Senator Warren because I think she was characterizing your 
Chapter 14 proposal of having a provision that says, ``Thou 
shalt not bail out banks.'' The only law that has something in 
it like that is actually Title II. What is important are not 
statements saying you will not bail them out, but, rather, 
frameworks that allow you to set up a mechanism so that, in 
fact, you can safely impose losses on creditors without 
creating runs, and that is what your bill actually would do, 
and that is why it would help.
    Although I do believe that one can resolve institutions 
using the single point of entry strategy under the existing 
Bankruptcy Code--and that is the key, it is being able to do it 
under that strategy--it is much better and it will be legally 
much more certain with your bill being enacted.
    And, let me just mention that all the key regulators around 
the world believe that is actually the single point of entry 
will avoid bailouts, and if you look at all the regulators in 
the U.S., you have former FDIC Chairman Sheila Bair saying, 
``This is a viable strategy.'' You have Governor Tarullo 
saying, ``best potential for the early resolution of the 
systemic financial firm.'' Fed Chairman Janet Yellen, ``very 
promising.'' Governor Jay Powell, ``a classic simplifier making 
theoretically possible something that seemed impossibly 
complex.'' President Dudley of the New York Fed, ``very much 
endorse the FDIC's single point of entry framework.'' Tom 
Baxter, General Counsel of the New York Fed, calling single 
point of entry a ``visionary breakthrough idea.'' Again, your 
bill would facilitate doing that under the Bankruptcy Code.
    So, the point is, is that if we can actually amend the 
Bankruptcy Code to make it absolutely certain that SPoE can be 
carried out successfully under the Bankruptcy Code, then, in 
fact, it will reduce the need for Title II, which, I think, is 
a good thing, because SPoE will now be carried out under a 
system that is rule based and predictable, and it is really the 
strategy that everybody believes works. No one is arguing 
whether Title II or bankruptcy are better. It is really the 
strategy, and the thing that you want to accomplish with your 
bill, and I think your bill accomplishes it, is to create a 
framework of bankruptcy law that will facilitate the single 
point of entry strategy being able to be carried out.
    Chairman Toomey. Professor Johnson, I want to give you a 
chance to respond, because I know you want to say something, 
but if you could do that briefly. I do have a quick question 
for Professor Jackson before my time expires.
    Mr. Johnson. I think you put the question brilliantly and 
with great clarity, Senator. And unfortunately, changes to the 
Bankruptcy Code being discussed today cannot create the 
expectation that this is what would happen to these firms 
because they are so global, and because we have agreed, 
actually, completely, that there can be no cooperation between 
global authorities in the event of these failures.
    And in Footnote 14 [of my testimony], I put a link to a 
corporate data base where they do a visualization of all the 
interconnections between these pieces of these banks across 
borders, and I really hope that you and your staff will look at 
it and look at the complexity there and think about how that 
unravels when the regulators do not cooperate in the event of 
bankruptcy. And, that is what Mr. Guynn said. They will not 
cooperate, only in the event of resolution, Title II, and we 
are trying to avoid Title II. So, under bankruptcy, there will 
be no cooperation. It will be a grab for assets globally and 
the whole thing will collapse.
    Chairman Toomey. Thank you, Professor Johnson.
    Let me touch on something. Professor Jackson, we have not 
talked about much yet, but I think it is worth mentioning. It 
is my understanding in Title II, the orderly liquidation 
authority, the bridge company that is contemplated is actually 
established as a Government entity----
    Mr. Jackson. Yes.
    Chairman Toomey. ----exempt from taxes. The FDIC appoints 
the management team. So, does the FDIC have the expertise to 
really oversee and manage an organization like this, and what 
are the implications of having this as a Government entity?
    Mr. Jackson. Well, I am quite concerned in terms of--I 
think markets regulate better than regulators most of the time, 
and that is why the bridge institution in bankruptcy is 
preferable to an FDIC running an institution. I am very 
uncomfortable with the idea that it is a Government entity 
exempt from taxation, because that prefers it over the other 
institutions that it is competing against. I think that is a 
big mistake in Dodd-Frank, to have done that in the first 
place.
    Commenting a little bit, I think the bankruptcy process 
that your bill invokes, I actually think--and here, I disagree 
a little bit with both Randy and with Professor Johnson, is 
something that I think the FDIC will back and the FDIC can sell 
it to the foreign regulators. They can make it clear that 
this--you are not concerned about the claims resolution process 
that might drag on for a year or 2 years in bankruptcy. You are 
talking about a recapitalization that occurs through the 
bankruptcy process, ends up with a bridge company that is not 
in bankruptcy 48 hours later. I do not think that is a 
particularly hard thing to sell to regulators with the backing 
of the FDIC, which I think they would back.
    Chairman Toomey. Thank you.
    Senator Merkley.
    Senator Merkley. Thank you very much.
    I wanted to submit for the record a letter from the 
National Bankruptcy Conference, if there is no objection to 
that.
    Chairman Toomey. Without objection.
    Senator Merkley. I found it interesting. It was addressed 
to the Judiciary Committee here in the Senate. It is from June 
18 of this year. But, they wanted to share some comments. They 
noted that the National Bankruptcy Conference is a nonpartisan, 
not-for-profit organization of 60 of the Nation's leading 
bankruptcy judges, professors, and practitioners, and it has 
provided advice to Congress on bankruptcy legislation for 80 
years.
    They did proceed to share in bullet form some of their 
concerns, and then this letter expands on each of them. The 
first point they make is that the Conference believes that a 
bankruptcy process might not be best equipped to offer the 
expertise, speed, and decisiveness needed to balance systemic 
risk and other competing goals in connection with resolution of 
a SIFI.
    The Conference strongly believes that laws in place with 
regard to a regulator-controlled SIFI resolution process, like 
the Federal Deposit Insurance Act and orderly liquidation 
authority under Title II, should continue to be available, even 
if special provisions are added to the Bankruptcy Code.
    They expand on that later, and then they note in their 
fourth bullet that the--and I will just summarize here--that 
any procedure contemplating the use of bankruptcy to 
recapitalize a SIFI should not include provisions that limit 
the availability of lender of last resort liquidity to a 
recapitalized firm, and then they expand on why that is 
important.
    And, of course, this is all directed toward that moment of 
chaos that we saw when companies that we may have thought were 
going to be incredibly strong and here forever suddenly find 
themselves having made big bets that go bad and the world 
changes overnight.
    But--so, I have submitted that for the record, but I wanted 
to turn to one piece of this puzzle that I thought maybe could 
have a little bit more expanded discussion, and this is the 
challenge of the international structure of these firms, where 
some of these firms may have, as I understand it, a thousand 
subsidiaries scattered across the globe and the bankruptcy 
process in the United States kind of extends to our borders, 
and whether there is sufficient power within the bankruptcy 
system to address the complexity of this sprawling holding 
companies. So, in that regard, in terms of the international 
dimensions, I just thought I would invite comment from any of 
you who would like to share.
    Yes, Mr. Johnson.
    Mr. Johnson. So, I have talked about this a great deal with 
counterparts in other parts of the world, and I will tell you 
what a senior former Bank of England official says. And, off 
the record, I will tell you afterwards exactly who this is and 
you can check it yourself. He says that there is a good chance 
they would cooperate with the FDIC if you are pursuing a Title 
II-type resolution. He says there is no chance, none, that the 
U.S. regulators would cooperate if you are following a Title I 
bankruptcy under current process. And, I am afraid that would 
also apply--well, you can show them this law and----
    Chairman Merkley. The U.S. regulators or that the----
    Mr. Johnson. The U.K. regulators, your foreign regulators--
--
    Chairman Merkley. OK.
    Mr. Johnson. Thank you--would not cooperate with the U.S. 
bankruptcy process. So, then you have Lehman-type chaos. That 
is the core of Lehman-type chaos.
    And, by the way, Senator, my understanding is the record 
number of subsidiaries right now is not 1,000, it is 15,000, 
one of these large companies, with very complicated 
interconnections that change on a daily basis. So, you have got 
to unravel that with no cooperation internationally. It 
collapses. It collapses like a house of cards, and that is what 
happened in September 2008.
    Chairman Merkley. Thank you.
    Other perspectives?
    Mr. Guynn. Yes. So, can I just explain why that is a red 
herring when you are using the bankruptcy for a single point of 
entry strategy. In a single point of entry, the only entity 
that actually goes into any kind of bankruptcy proceeding is 
the U.S. parent. The U.K. subsidiaries stay open and operating. 
They are recapitalized. They have enough liquidity. So, there 
really is not any decision for the U.K. regulatory authorities 
to do or to cooperate with in that situation. So, I think it is 
really overblown.
    Part of the reason for actually inventing single point of 
entry was to address the cross-border issues that would have 
arisen if you actually put an institution into a receivership 
or insolvency proceeding with branches in different countries, 
where if you tried to do a transfer to a bridge, you would 
actually need approval of regulatory authorities and 
counterparties if you were to transfer, for instance, a bank to 
a bridge bank. Those issues are avoided when you do the single 
point of entry under this bill. So, that is basically my 
response.
    Chairman Merkley. OK. So, Professor Taylor, and then we 
will return to Professor Johnson.
    Mr. Taylor. Just very briefly, I think one way to get a 
handle on this important question is to think about what would 
have happened in the case of Lehman Brothers had this existed, 
and we have worked through that in a lot of detail. And, 
assuming that the existing bail-in mechanism in the European 
Union exists, and it works fine. It is just exactly what Mr. 
Guynn and Mr. Jackson are talking about. There is not that much 
need for coordination. I cannot believe the regulators would 
stiff us on something like this. There is plenty of time to 
communicate, and it works together with our current bail-in 
process.
    Chairman Merkley. So, dramatically different points of 
view. Professor Johnson's, and then, Mr. Guynn, you are noting 
that it is a red herring, and Professor Taylor, that it would 
work just fine. Back to Professor Johnson.
    Mr. Johnson. Senator, I work on international policy 
coordination issues for a long time. This is not a red herring 
and nobody is stiffing anyone. They have a legal requirement in 
the United Kingdom and other jurisdictions to protect their own 
taxpayers, protect people who have claims on the legal entities 
there. In the event of the failure of Lehman, the concern of 
the U.K. was, or the question was, who owns what within that 
complex set of firms. The cash is in London at this moment. 
Perhaps it belongs to the U.K. company. Perhaps it belongs to 
the U.S. company. Perhaps it belongs to the Cayman company. We 
freeze the cash. The first thing we do is we freeze the cash.
    Now, under Title II, and that is the point of the 
Memorandum of Understanding between the FDIC and the Bank of 
England, the Bank of England has agreed to back off for as long 
as they believe that you are doing the single point of entry 
under Title II. So, we will see if that works.
    That is not available under bankruptcy. That is not what 
they will do if you are pursuing either bankruptcy with these 
current complex global entities under the existing code or 
under the code with the modifications being suggested by the 
panel or by the Chairman today. That is not the world in which 
we live.
    Senator Merkley. Thank you. And, the world within which we 
live is limited in time, and thank you very much, all of you, 
for bringing your expertise to bear on this. I think we are 
going to have more discussions as time passes and you have 
added a great deal. Thank you.
    Chairman Toomey. And, I want to thank all of the witnesses, 
as well. I think we have had a very helpful, very constructive 
discussion at advancing the cause and the understanding of this 
issue. So, I want to thank the witnesses and thank the Ranking 
Member for attending and participating.
    The hearing is adjourned.
    [Whereupon, at 11:54 a.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
                 PREPARED STATEMENT OF RANDALL D. GUYNN
                   Partner, Davis Polk & Wardell, LLP
                             July 29, 2015
    Thank you for inviting me to testify on the role of bankruptcy 
reform in addressing too big to fail (TBTF). I am the head of the 
Financial Institutions Group at Davis Polk & Wardwell LLP. \1\ I am 
also the Cochair of the Failure Resolution Task Force of the Financial 
Regulatory Reform Initiative of the Bipartisan Policy Center. I have 
written a number of articles and participated in a number of debates on 
the nature of the TBTF problem and how to solve it. \2\ Like most U.S. 
and foreign regulators, financial industry groups, think tanks, rating 
agencies, and other stakeholders, \3\ I believe that the most promising 
solution to the TBTF problem for most of the U.S. and foreign banking 
organizations that have been designated by the Financial Stability 
Board (FSB) as global systemically important banking groups (G-SIBs) is 
the single-point-of-entry (SPoE) recapitalization within resolution or 
bankruptcy strategy.
---------------------------------------------------------------------------
     \1\ My practice focuses on providing bank regulatory advice to the 
largest and most systemic U.S. and foreign banking organizations, as 
well as to a wide range of U.S. regional, midsize, and community banks. 
This focus includes advice on mergers and acquisitions, capital 
markets, and other transactions when the target or issuer is a banking 
organization. I am the editor of Regulation of Foreign Banks and 
Affiliates in the United States (Thomson Reuters: 8th ed. 2014), the 
leading treatise in the area.
     \2\ See, e.g., Randall D. Guynn, ``Framing the TBTF Problem: The 
Path to a Solution'', in Across the Divide: New Perspectives on the 
Financial Crisis (Hoover Institution and Brookings Institution: Martin 
Neil Baily and John B. Taylor, eds., 2014); John F. Bovenzi, Randall D. 
Guynn, and Thomas H. Jackson, ``Too Big to Fail: The Path to a 
Solution, A Report of the Failure Resolution Task Force of the 
Financial Regulatory Reform Initiative of the Bipartisan Policy 
Center'' (BPC Report); Randall D. Guynn, ``Resolution Planning in the 
United States'', in The Bank Recovery and Resolution Directive--
Europe's Solution for ``Too Big To Fail''? (De Gruyter: Andreas Dombret 
and Patrick Kenadjian, eds., 2013); Randall D. Guynn, ``Are Bailouts 
Inevitable?'', 29 Yale Journal on Regulation 121 (2012); Debate Between 
Dean Paul Mahoney of the University of Virginia School of Law and 
Randall D. Guynn, ``Are Bailouts Inevitable?'' (available at: http://
volokh.com/2011/03/04/uva-debate-are-bailouts-inevitable-under-dodd-
frank/).
     \3\ Guynn, ``Framing the TBTF Problem'', supra note 2, at 282-286.
---------------------------------------------------------------------------
    During the past few years, I have spent a significant portion of my 
time working on resolution plans for a number of U.S. and foreign 
banking organizations under Section 165(d) of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act (the Dodd-Frank Act). I have 
also represented a number of financial industry trade organizations, 
including The Clearing House Association, the Securities Industry and 
Financial Markets Association, the Global Financial Markets 
Association, and the Financial Services Forum on issues related to 
recovery and resolution planning, including the ISDA Resolution Stay 
Protocol (the ``ISDA Protocol'') \4\ and the FSB's proposal on total 
loss-absorbing capacity (TLAC). \5\ I am here today, however, in my 
individual capacity and not on behalf of any client, although I expect 
to be asked by clients to help them evaluate the various proposals for 
bankruptcy reform.
---------------------------------------------------------------------------
     \4\ International Swaps and Derivatives Association, Inc., ISDA 
2014 Resolution Stay Protocol (Nov. 4, 2014).
     \5\ Financial Stability Board, ``Adequacy of Loss-Absorbing 
Capacity of Global Systemically Important Banks in Resolution'', 
Consultative Document (Nov. 10, 2014).
---------------------------------------------------------------------------
    Congress is currently considering two bankruptcy reform proposals 
that are designed to address the TBTF problem. Both are based on the 
pioneering work of the Hoover Institution on a proposed new Chapter 14 
of the Bankruptcy Code. \6\ The House passed H.R. 5421, the Financial 
Institutions Bankruptcy Act (FIBA), last year, and is considering a 
nearly identical version of it this year. Two years ago, Senators 
Cornyn and Toomey introduced S. 1861, the Taxpayer Protection and 
Responsible Resolution Act (TPRRA). This year, they have introduced a 
substantially revised version of TPRRA. Both the Senate and House bills 
are modeled on the SPoE portion of what the Hoover Institution calls 
Chapter 14 2.0. \7\ That portion of the revised version of the original 
Chapter 14 proposal is designed specifically to facilitate an SPoE 
strategy (or what Professor Jackson calls the one-entity or two-entity 
recapitalization approach) under the Bankruptcy Code. \8\
---------------------------------------------------------------------------
     \6\ See, e.g., Bankruptcy Not Bailout: A Special Chapter 14 
(Hoover Institution: Kenneth E. Scott and John B. Taylor, eds., 2012); 
Making Failure Feasible: How Bankruptcy Reform Can End ``Too-Big-To-
Fail'' (Hoover Institution: Kenneth E. Scott, Thomas H. Jackson, and 
John B. Taylor, eds., 2015).
     \7\ Thomas H. Jackson, ``Building on Bankruptcy: A Revised Chapter 
14 Proposal for the Recapitalization, Reorganization, or Liquidation of 
Large Financial Institutions'', in Making Failure Feasible, supra note 
6, at 23; David A. Skeel, Jr., ``Financing Systemically Important 
Financial Institutions'', in Making Failure Feasible, supra note 6, at 
62; John B. Taylor, ``Preface'', in Making Failure Feasible, supra note 
6, at xii; William F. Kroener III, ``Revised Chapter 14 2.0 and Living 
Will Requirements Under the Dodd-Frank Act'', in Making Failure 
Feasible, supra note 6, at 247.
     \8\ See supra note 7.
---------------------------------------------------------------------------
    This statement first discusses the nature of the TBTF problem. It 
then describes the SPoE strategy, including how it works, how it 
inevitably results in a substantial shrinkage of the failed banking 
group and why it is a viable solution to the TBTF problem. It then 
discusses the changes made since the 2008 global financial crisis to 
make U.S. banking groups more resilient against failure. Next, it 
describes the major structural changes that have been made by the U.S. 
G-SIBs so that they are safe to fail. \9\ Finally, it discusses how 
bankruptcy reform can improve the ability of the Bankruptcy Code to 
address too big to fail.
---------------------------------------------------------------------------
     \9\ Cf. Thomas Huertas, Safe To Fail: How Resolution Will 
Revolutionise Banking (Palgrave Macmillan: 2014).
---------------------------------------------------------------------------
1. Nature of the TBTF Problem
    The TBTF problem arises if policymakers do not believe they can 
allow certain large, systemically important banking groups to fail and 
impose losses on their private sector investors without risking the 
sort of contagious runs by short-term creditors or a disruption in 
critical operations that can destabilize the financial system. \10\ 
Faced with a dilemma between taxpayer-funded bailouts and a potential 
collapse of the financial system, policymakers tend to choose bailouts 
as the lesser of two evils. \11\ If there were no viable solution to 
that dilemma, bailouts would almost certainly be inevitable. \12\ 
Thomas Huertas provides a good discussion of why TBTF is a problem and 
why it should be solved in Safe To Fail: How Resolution Will 
Revolutionise Banking. \13\
---------------------------------------------------------------------------
     \10\ Douglas Diamond and Philip Dybvig, ``Bank Runs, Deposit 
Insurance, and Liquidity'', 91 Journal of Political Economy 401 (1983); 
Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve 
System, Remarks at The Clearing House 2014 Annual Conference, New York, 
New York, at 2 (Nov. 20, 2014).
     \11\ BPC Report supra note 2, at 1; ``Guynn, Are Bailouts 
Inevitable?'', supra note 2, at 127-129.
     \12\ Guynn, ``Are Bailouts Inevitable?'', supra note 2, at 129. 
See also Thomas F. Huertas, ``A Resolvable Bank'', in Making Failure 
Feasible, supra note 6, at 129 (``A resolvable bank is one that is 
`safe to fail': it can fail and be resolved without cost to the 
taxpayer and without significant disruption to the financial markets or 
the economy at large.'').
     \13\ Huertas, supra note 7, chapter 1, at 4-20.
---------------------------------------------------------------------------
2. The Single-Point-of-Entry Strategy
    But there is a viable solution if certain conditions are satisfied. 
It is called the SPoE resolution strategy. That strategy was originally 
developed by the FDIC under Title II of the Dodd-Frank Act. \14\ It was 
subsequently endorsed by the Bank of England as the most promising 
strategy for dealing with failed G-SIBs without the need for taxpayer-
funded bailouts and without causing the sort of contagion that can 
destabilize the financial system. \15\ The European Union added 
language to its Bank Recovery and Resolution Directive authorizing 
resolution authorities at both the member state and union levels to 
resolve European banking and other financial organizations using the 
SPoE strategy. \16\ The Failure Resolution Task Force at the Bipartisan 
Policy Center recognized that the SPoE strategy could be carried out 
under existing Chapter 11 of the Bankruptcy Code, but recommended that 
a new Chapter 14 be enacted to increase the legal certainty of SPoE 
under the Bankruptcy Code. \17\
---------------------------------------------------------------------------
     \14\ Martin J. Gruenberg, Acting Chairman, FDIC, Remarks to the 
Federal Reserve Bank of Chicago Bank Structure Conference (May 10, 
2012).
     \15\ FDIC and Bank of England, Joint Paper, ``Resolving Globally 
Active, Systemically Important, Financial Institutions'' (Dec. 10, 
2012); Martin J. Gruenberg, Chairman, FDIC, and Paul Tucker, Deputy 
Governor, Financial Stability, Bank of England, ``Global Banks Need 
Global Solutions When They Fail'', Financial Times, Op. Ed. (Dec. 10, 
2012; Bank of England, ``The Bank of England's Approach to Resolution'' 
(October 2014).
     \16\ Directive 2014/15/EU of the European Parliament and of the 
Council of 15 May 2014 establishing a framework for the recovery and 
resolution of credit institutions and investment firms and amending 
Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 
2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU and 2013/36/
EU, and Regulations (EU) No. 1093/2010 and (EU) No. 648/2012, of the 
European Parliament and of the Council.
     \17\ BPC Report, supra note 2, at 33-35.
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a. How SPoE Works
    Under the SPoE strategy, the top-tier parent of a U.S. banking 
group would be put into a special resolution proceeding under Title II 
of the Dodd-Frank Act or a Chapter 11 bankruptcy proceeding. The FDIC 
under Title II or the debtor-in-possession in a Chapter 11 proceeding 
would establish a new financial holding company (FHC) called a bridge 
FHC (because it is a temporary bridge to an exit from the receivership 
or bankruptcy proceeding). All of the assets of the failed parent, 
including is ownership interests in its operating subsidiaries, would 
be transferred to the bridge FHC. This would be done in a bankruptcy 
proceeding, with court approval, pursuant to Section 363 of the 
Bankruptcy Code. All of the shares and long-term unsecured debt of the 
failed parent would remain behind in the receivership or bankruptcy 
proceeding. Only a limited amount of critical operating liabilities, 
such as those to the electric company or critical vendors as well as 
parent guarantees, would be assumed by the bridge FHC, making it 
essentially debt-free.
    The parent or bridge FHC would recapitalize any operating 
subsidiaries that suffered losses by forgiving intercompany receivables 
or otherwise contributing assets to the subsidiaries. It would do so 
because the franchise values of operating subsidiaries are almost 
always substantially greater than their liquidation values. Thus, 
recapitalizing the operating subsidiaries should maximize their value 
for the benefit of the failed parent's stakeholders.
    At least in a bankruptcy proceeding the bridge FHC would be 
transferred to an independent trust, which would hold the interest in 
the bridge FHC for the benefit of the bankruptcy estate. The trustees 
of the trust would include experienced and highly regarded bankers, 
former regulators and others. The trust would enter into an agreement 
approved by the bankruptcy court that would spell out the duties of the 
trust to the bankruptcy estate. One key benefit of the trust would be 
to help gain public confidence in the stability of the bridge FHC.
    Once the business transferred to the bridge FHC stabilizes, the 
FDIC or the trust would convert the bridge to an ordinary bank holding 
company (New HoldCo) and sell all or a portion of the shares in New 
HoldCo to the public and distribute the net proceeds and any unsold 
shares to the receivership or bankruptcy estate. The net proceeds and 
any unsold shares would then be distributed to the failed parent's 
stakeholders in accordance with the priority of their claims.
    A step-by-step illustration of how an SPoE strategy works is 
included in the BPC Report, \18\ and attached to this Statement as 
Exhibit A.
---------------------------------------------------------------------------
     \18\ BPC Report, supra note 2, at 23-32.
---------------------------------------------------------------------------
b. Principal Strategy Under Title I Resolution Plans
    All but two of the U.S. G-SIBs recently disclosed in the public 
summaries of their 2015 resolution plans submitted under Section 165(d) 
of the Dodd-Frank Act that their principal strategies for being 
resolved under the Bankruptcy Code is an SPoE strategy under existing 
Chapter 11 of the Bankruptcy Code. \19\
---------------------------------------------------------------------------
     \19\ See the FDIC's Web site, https://www.fdic.gov/regulations/
reform/resplans/index.html, or the Federal Reserve's Web site, http://
www.federalreserve.gov/bankinforeg/resolution-plans.htm. The firms that 
used the SPoE strategy as their principal strategy were Bank of 
America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and 
State Street. The firms that did not use the SPoE strategy as their 
principal strategy were the Bank of New York Mellon and Wells Fargo. 
The principal strategy used by those firms was a multiple-point-of-
entry (MPoE) strategy whereby the businesses of their flagship banks 
were transferred to bridge banks and then, over time, broken up and 
sold in an FDIC receivership and their material nonbank subsidiaries 
were sold to third parties as going concerns or wound down in their 
respective insolvency proceedings.
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c. What Comes Out of the SPoE Hopper Is Not What Goes In
    As shown by the step-by-step illustration of the SPoE strategy in 
the BPC Report, \20\ and attached to this Statement as Exhibit A, the 
SPoE strategy results in the resolution, not the resurrection of a 
failed banking group. The banking group that emerges from an SPoE 
strategy is always significantly smaller than it was before its top-
tier parent failed. Under the stylized balance sheets used in the BPC 
Report, the banking group that emerged from the SPoE was half the size 
of the banking group just before its top-tier parent failed (total 
assets dropped from 100 to 50), as illustrated by Figures 1 and 7. \21\ 
This is mainly a function of the fundamental nature of the SPoE 
process, as illustrated by Figure 2 in the BPC Report (where total 
assets dropped from 100 to 59, to reflect the hypothetical losses 
suffered by the group). \22\ But it may also result from the sale of 
certain assets during the SPoE process if that would be consistent with 
maximizing the value of the firm and minimizing its losses for the 
benefit of the top-tier parent's stakeholders left behind in the Title 
II receivership or bankruptcy proceeding, as illustrated by Figure 6 in 
the BPC Report. \23\
---------------------------------------------------------------------------
     \20\ BPC Report, supra note 2, at 23-32.
     \21\ Id. at 24, 30.
     \22\ Id. at 25.
     \23\ Id. at 30.
---------------------------------------------------------------------------
    This shrinkage principle is illustrated by the public summaries of 
the 2015 Title I resolution plans recently filed by the U.S. G-SIBs. 
\24\ According to the firms that used the SPoE strategy as their 
principal strategy, \25\ the firm that emerged from the SPoE process 
was substantially smaller than the firm that entered the process. For 
example, Bank of America and JPMorgan Chase reported that their main 
bank subsidiaries would shrink by approximately 33 percent and their 
broker-dealer subsidiaries would shrink by 66-80 percent. \26\ State 
Street reported that its flagship bank would shrink by 50 percent and 
it might sell its investment management businesses outside of 
insolvency proceedings as going concerns. \27\ Citigroup, Goldman 
Sachs, and Morgan Stanley all reported that they would cease to exist 
because they would sell their operations to third parties in public or 
private offerings or wind them down outside of any insolvency 
proceedings as part of the SPoE process. \28\ The shrinkage principle 
in the SPoE strategy, of course, is quite different from breaking up 
healthy banks for political reasons. Any shrinkage occurring as part of 
the SPoE strategy is simply a by-product of incurring losses and 
attempting to maximize the value of the enterprise and minimize its 
losses for the benefit of the failed parent's stakeholders.
---------------------------------------------------------------------------
     \24\ See supra note 19.
     \25\ Id.
     \26\ Id. (see public summaries for Bank of America and JPMorgan 
Chase).
     \27\ Id. (see pubic summary for State Street).
     \28\ Id. (see public summaries of Citigroup, Goldman Sachs and 
Morgan Stanley).
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d. SPoE Is a Viable Solution
    The SPoE strategy is a viable solution to the TBTF problem if three 
essential conditions are satisfied.
            (1) Sufficient Usable TLAC
    First, the failed parent must have enough TLAC (i.e., combined 
equity and long-term unsecured debt) for the business that is 
transferred to the bridge FHC to be fully recapitalized after suffering 
losses in a sufficiently severe adverse economic scenario and the TLAC 
must be usable. By usable, I mean the group's losses can be imposed on 
the parent's private sector TLAC investors without fostering runs by 
the group's short-term creditors, which in turn can foster contagion 
throughout the financial system. \29\ The key to being able to do so is 
separating the TLAC and other capital structure liabilities from short-
term unsecured debt and other operating liabilities, and making the 
capital structure liabilities subordinate to the operating liabilities 
(or conversely making the operating liabilities senior to the capital 
structure liabilities). \30\ As a result, both shareholders and long-
term unsecured debt investors are expected to bear losses, a result 
that would be fundamentally different from the 2008 global financial 
crisis when long-term bondholders were generally insulated from losses 
and only shareholders bore losses.
---------------------------------------------------------------------------
     \29\ Huertas, supra note 12, at 129.
     \30\ Id., at 29-30. I believe that I was the first person to 
suggest this sort of separation and subordination of capital structure 
liabilities to operating liabilities in connection with the Financial 
Stability Board's Private Sector Bail-in Initiative, of which I was a 
member. That concept is now embedded in the FSB's TLAC proposal. See 
FSB, supra note 5. It was developed in response to what I found to be a 
persuasive criticism of the FDIC's discretion to discriminate among 
similarly situated creditors in Section 210(b)(4) of Title II of the 
Dodd-Frank Act, as long as the disfavored creditors receive at least as 
much as they would have received in a liquidation under Chapter 7 of 
the Bankruptcy Code (the ``no creditor worse off than in liquidation'' 
or ``NCWOL'' principle). Kenneth E. Scott, ``A Guide to the Resolution 
of Failed Financial Institutions: Dodd-Frank Title II and Proposed 
Chapter 14'', in Bankruptcy Not Bailout, supra note 6, at 11-12, 17 
(``For my purposes, a bailout occurs when some favored claimants on a 
failed financial firm are given more than what they would receive in an 
ordinary bankruptcy, at the expense of others.''). When I tried to 
analyze why the FDIC needed the power to discriminate among similarly 
situated creditors, it seemed to me that the only legitimate reason was 
to be able to treat short-term unsecured creditors as if they were 
senior to long-term unsecured creditors during a financial panic in 
order to stem runs and contagion. A rule of separation and 
subordination seemed superior to a discretionary power to achieve the 
same end since the discretionary power arguably resulted in an 
unexpected transfer of value from one group of creditors to another 
without compensation, meaning it could give rise to moral hazard since 
the favored creditors would not internalize the costs of their 
unexpected favored position. In contrast, with a clear nondiscretionary 
rule of separation and subordination in place, the market would force 
short-term unsecured creditors to internalize the costs of their 
preferred status by reducing the amount of interest or other return 
they could demand. At the same time, it would allow long-term unsecured 
debt holders to demand a return that was sufficient to compensate them 
for the increased risk they would bear.
---------------------------------------------------------------------------
    The easiest way for U.S. bank holding companies to make TLAC usable 
is to make it structurally subordinate to the group's short-term 
unsecured debt. \31\ This can be achieved by moving any short-term 
unsecured debt from the parent to its operating subsidiaries. The TLAC 
investors will then absorb all losses incurred by the group before any 
of the short-term unsecured creditors suffers any losses. Because the 
TLAC would act as a shield against losses by the short-term creditors, 
imposing losses on TLAC investors should reduce the incentive of the 
group's short-term unsecured creditors to run. To the extent this 
subordination framework makes short-term unsecured debt less risky, the 
market will force short-term unsecured creditors to internalize the 
costs of their preferred position (and thereby eliminate any moral 
hazard) by decreasing the returns they would otherwise be able to 
demand on short-term unsecured debt.
---------------------------------------------------------------------------
     \31\ Other less practical ways are to amend outstanding long-term 
senior unsecured debt to make it contractually subordinate to short-
term unsecured debt or to persuade Congress to enact a statutory 
priority scheme that makes long-term unsecured debt subordinate to 
short-term unsecured debt.
---------------------------------------------------------------------------
            (2) Sufficient Liquidity
    Second, the business transferred to the bridge FHC must have access 
to a sufficient amount of liquidity in a Title II or bankruptcy 
proceeding for the business to be stabilized after it has been 
transferred to the largely debt-free bridge FHC. If the business does 
not have sufficient liquidity, it may be forced to sell illiquid assets 
at fire-sale prices, which can cause an otherwise solvent bridge FHC to 
become insolvent. \32\ A well-capitalized bridge FHC should be able to 
obtain secured liquidity from the market under normal market 
conditions. \33\ But if the market for secured liquidity is 
dysfunctional, as it typically is during a financial crisis, the FDIC 
has the power to supplement the amount of secured liquidity available 
from the market in a Title II proceeding. \34\
---------------------------------------------------------------------------
     \32\ Diamond and Dybvig, supra note 10.
     \33\ Skeel, supra note 7, at 65-67.
     \34\ Dodd-Frank Act, 210(n) (Orderly liquidation fund).
---------------------------------------------------------------------------
    There is no similar Government source of back-up secured liquidity 
in a bankruptcy proceeding, and TPRRA would prohibit the Federal 
Reserve bank from making advances to a covered financial company or a 
bridge financial company for the purpose of providing court-approved 
debtor-in-possession financing. \35\ A U.S. G-SIB that is required to 
show it can be resolved under the Bankruptcy Code without any access to 
secured liquidity from a Government source will be forced to hold far 
more cash and other high quality liquid assets (HQLAs) than otherwise 
in order to show it will have enough liquidity in a hypothetical, 
future bankruptcy proceeding. Such a requirement will reduce the amount 
of credit the U.S. G-SIBs can supply to the market. \36\ It will also 
provide an incentive for U.S. G-SIBs to hoard liquidity during a 
financial crisis, when it is most needed by the market. \37\
---------------------------------------------------------------------------
     \35\ Skeel, supra note 7, at 63.
     \36\ Tarullo, supra note 10, at 5-6.
     \37\ Id. at 6, 18.
---------------------------------------------------------------------------
    To illustrate the impact of such a liquidity requirement on the 
supply of credit, consider how the money multiplier works. If all banks 
were subject to a 10 percent reserve requirement (RR), it would mean 
that they are required to set aside $10 in cash for every $100 in loans 
they make. Since the potential money multiplier is 1/RR, it also means 
that every dollar of central bank money injected into the banking 
system by the Federal Reserve has the potential to multiply into 10 
times the amount of money and credit throughout the banking system. 
\38\ If the reserve requirement is increased to 20 percent, the amount 
of potential credit available to the system will shrink by 5 times the 
amount of central bank money (-500 percent) originally injected into 
the system. The point is not to say whether 10 percent or 20 percent is 
the correct reserve requirement, but to illustrate that there is a 
tradeoff between the amount of the reserve requirement and the amount 
of money and credit that can potentially be made available to the 
market. \39\
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     \38\ See, e.g., James R. Kearl, Economics and Public Policy: An 
Analytical Approach 422-427, 792 (Pearson: 6th ed., 2011).
     \39\ See, e.g., Tarullo, supra note 10, at 5-6.
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    Liquidity requirements have the same effect on the supply of money 
and credit as reserve requirements. \40\ If U.S. G-SIBs are required to 
hold twice as much cash and HQLAs as they would be required to hold if 
a Government source of secured liquidity were available in a 
hypothetical, future bankruptcy proceeding, the potential amount of 
credit they can supply to the market will shrink in advance by 
approximately 5 times the amount of central bank money (-500 percent) 
originally injected into the system by the Federal Reserve. In other 
words, there is a serious tradeoff between the potential amount of 
credit the U.S. G-SIBs can provide to the market now and the benefits 
of prohibiting the Federal Reserve from using any of its lender-of-
last-resort (LOLR) facilities to provide liquidity to fully 
recapitalized bridge FHCs in a future, hypothetical bankruptcy 
proceeding. Assuming that the Federal Reserve would provide such 
liquidity in accordance with the classic rules laid down by Walter 
Bagehot \41\--i.e., only on a fully secured basis to solvent bridge 
FHCs at appropriate above-market interest rates--it would seem as if 
the risk of loss to the Federal Reserve and the risk of creating any 
moral hazard would be essentially zero. It therefore seems as if the 
tradeoff strongly favors the availability of a properly structured LOLR 
facility to serve as a back-up source of secured liquidity in a 
bankruptcy proceeding. \42\
---------------------------------------------------------------------------
     \40\ Indeed, reserve requirements are a type of liquidity 
regulation. Id. at 18, note 18.
     \41\ Walter Bagehot, Lombard Street: A Description of the Money 
Market (1873).
     \42\ See David A. Skeel, Jr., supra note 7, at 65, 74-75, 81-85. 
Indeed, Professor Skeel argues that Congress should amend Section 13(3) 
of the Federal Reserve Act to expressly authorize the Federal Reserve 
to provide secured liquidity to bridge financial companies and their 
operating subsidiaries in order to facilitate an SPoE strategy under 
the Bankruptcy Code. Id. at 65.
---------------------------------------------------------------------------
    For the reasons described in the BPC Report, it is important for 
policymakers to distinguish between capital and liquidity. \43\ 
Government programs like the Troubled Asset Relief Program (TARP) 
provided equity capital to both viable and troubled financial firms. 
TARP bailed out the private sector investors of otherwise insolvent 
firms by protecting them against losses without requiring those 
investors to compensate the Government for providing such protection. 
In contrast, traditional LOLR facilities provide only temporary fully 
secured liquidity at above-market interest rates to solvent firms with 
sufficient capital. If properly structured, such facilities expose the 
Government to no risk of loss and require borrowers to adequately 
compensate it for the small amount of liquidity risk it assumes. \44\ 
Thus, it is fair and appropriate to label Government injections of 
capital such as those made under the Capital Purchase Program of TARP 
as bailouts, \45\ but it is wrong to label properly structured LOLR 
facilities as bailouts.
---------------------------------------------------------------------------
     \43\ BPC Report, supra note 2, at 19.
     \44\ Tarullo, supra note 10, at 9. Paul Tucker, The lender of last 
resort and modern central banking principles and reconstruction, BIS 
Papers No. 79 (Sept. 2014).
     \45\ See Davis Polk, A Guide to the Laws, Regulations ,and 
Contracts of the Financial Crisis, chapter 3 (Margaret Tahyar, ed., 
September 2009).
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            (3) Mitigation of QFC Cross-Defaults
    Third, and related to the second, a material amount of the 
qualified financial contracts (QFCs) at the group's operating 
subsidiary level must not contain cross-defaults to the parent's 
failure. Alternatively, any such cross-defaults must be overridden 
contractually, for example, as provided by the ISDA Protocol or a 
similar contractual arrangement or by regulation or statute. Otherwise, 
such cross-defaults would allow the QFCs to be terminated and drain 
liquidity out of the group even if the operating subsidiaries have been 
recapitalized and are performing on those QFCs. In addition, collateral 
securing the QFCs would be dumped on the market, putting downward 
pressure on asset values. Such a potential drainage of liquidity would 
require U.S. G-SIBs to carry even more cash and HQLAs in order to be 
sure they would have enough liquidity in a hypothetical, future 
bankruptcy proceeding, putting further pressure on their ability to 
supply credit to the market and increasing their incentive to hoard 
liquidity during a financial crisis. \46\
---------------------------------------------------------------------------
     \46\ Tarullo, supra note 10, at 6, 18.
---------------------------------------------------------------------------
3. U.S. Banking Groups Are More Resilient
    U.S. banking groups have taken substantial actions to make 
themselves more resilient against failure since the 2008 global 
financial crisis. For example, as shown in Exhibit B, the largest, most 
systemic banking groups have nearly twice as much capital as they had 
on the eve of the 2008 financial crisis. They are also projected to 
have more capital in a stressed environment than they had actual 
capital in 2008. This makes them more resilient against insolvency. 
They also have significantly more liquid balance sheets, making them 
more resilient against runs, as illustrated in Exhibit C. They have 
three times (3X) the amount of HQLAs compared to 2008, and five times 
(5X) the amount of cash. They have also reduced their reliance on 
short-term wholesale funding, as shown in Exhibit D. U.S. regulatory 
standards increase with the size and complexity of U.S. and foreign 
banking organizations, as shown in Exhibit E.
4. U.S. G-SIBs Are Safe To Fail Under the Bankruptcy Code
    The U.S. G-SIBs have made major structural changes so that they 
will be safe to fail under the Bankruptcy Code. \47\
---------------------------------------------------------------------------
     \47\ Cf. Huertas, supra note 9.
---------------------------------------------------------------------------
a. More Usable TLAC
    The most important structural change that almost no one has heard 
of relates to usable TLAC, as illustrated on Exhibit F. The U.S. G-SIBs 
had, on average, nominal TLAC equal to approximately 17 percent of 
their risk-weighted assets (RWAs) in 2008.
    Unfortunately, only tangible common equity turned out to be loss-
absorbing without risking contagion because of how the TLAC was 
structured, and tangible common equity amounted to only 5 percent of 
RWAs. Losses could not legally be imposed on long-term senior unsecured 
debt without causing contagion because it ranked equally with short-
term senior unsecured debt issued at the parent level. There was no 
provision in the Bankruptcy Code that allowed bankruptcy courts to 
discriminate among similarly situated creditors unless it would 
maximize the value of the enterprise for the benefit of the disfavored 
creditors. \48\ Although losses could theoretically have been imposed 
on subordinated debt, preferred equity and trust preferred securities 
without causing contagion, the market was confused about the relative 
priority among those instruments and long-term senior unsecured debt so 
policymakers worried about causing contagion if such securities were 
allowed to suffer any losses.
---------------------------------------------------------------------------
     \48\ See, e.g., Douglas G. Baird, Elements of Bankruptcy 225-226 
(5th ed. 2010). In contrast, the FDIC has the discretion to treat 
similarly situated creditors differently under Section 210(b)(4) of the 
Dodd-Frank Act as long as the disfavored creditors receive at least as 
much as they would have received in a liquidation under Chapter 7 of 
the Bankruptcy Code.
---------------------------------------------------------------------------
    Today the U.S. G-SIBs have, on average, nominal TLAC equal to 
approximately 25 percent of RWAs, as illustrated by Exhibit F. More 
importantly, they have restructured their TLAC so that it is all usable 
to absorb losses without causing contagion. \49\ This means that they 
have five times (5X) the amount of usable TLAC (which consists of both 
equity and long-term unsecured debt) compared to what they had during 
the 2008 global financial crisis. They have achieved this result by 
moving virtually all of the short-term unsecured debt that used to be 
issued by their top-tier parent companies to their operating 
subsidiaries. Long-term senior unsecured debt can now be left behind in 
an FDIC receivership or bankruptcy proceeding of the parent without 
imposing losses on the group's short-term unsecured debt. This amount 
of TLAC should be enough to recapitalize the business transferred to a 
bridge FHC at full Basel III capital levels under conditions twice as 
severe as the 2008 global financial crisis.
---------------------------------------------------------------------------
     \49\ See Huertas, supra note 12, at 129.
---------------------------------------------------------------------------
    Both the market and the regulators expect this structural change to 
make U.S. G-SIBs more resolvable under the Bankruptcy Code, as shown on 
Exhibit G. For example, Fitch and Moody's have eliminated any uplift on 
the ratings of U.S. G-SIBs based on an expectation of Government 
support because Government bailouts are no longer expected. \50\ 
Standard & Poor's has indicated that it may eliminate any uplift based 
on an expectation of Government support. \51\ The spreads on long-term 
unsecured debt of U.S. G-SIBs are now higher than the spreads on long-
term unsecured debt issued by other U.S. banks. \52\
---------------------------------------------------------------------------
     \50\ Government Accounting Office, ``Large Bank Holding Companies: 
Expectations of Government Support'', at 25-26 (July 2014). Moody's 
Investors Service, ``Rating Action: Moody's Concludes Review of Eight 
Large U.S. Banks'' (Nov. 14, 2013).
     \51\ GAO, supra note 50.
     \52\ Id. at 50-52.
---------------------------------------------------------------------------
b. Increased Liquidity
    As noted above, the U.S. G-SIBs have substantially more cash and 
HQLAs than in 2008. Several of them have increased their cash and HQLAs 
in order to show they would have enough liquidity to carry out an SPoE 
resolution strategy under Chapter 11, assuming no access to secured 
liquidity from any Government LOLR facility. This new liquidity 
requirement may have already started to result in a higher effective 
liquidity requirement than either the Basel III liquidity coverage 
ratio or net stable funding ratio. It raises serious public policy 
questions whether this new liquidity requirement is justified in light 
of the negative impact it may already be having on the potential amount 
of credit that the U.S. G-SIBs are able to provide to the U.S. economy. 
\53\
---------------------------------------------------------------------------
     \53\ Tarullo, supra note 10, at 5-6, 18.
---------------------------------------------------------------------------
c. Mitigation of QFC Cross-Defaults
    Five of the eight U.S. G-SIBs \54\ are among the 18 G-SIBs \55\ 
that agreed to adhere to the new ISDA Resolution Stay Protocol. As 
summarized in the slide attached as Exhibit H, the ISDA Protocol 
overrides cross-defaults in ISDA financial contracts among the 18 
adhering G-SIBs based on a parent's or other affiliate's bankruptcy or 
entry into resolution. The adhering U.S. G-SIBs have also supported 
regulations to expand the principles of the ISDA Protocol to more 
counterparties and financial contracts. No similar mechanism existed 
during the 2008 financial crisis. According to the Financial Stability 
Board, ``[w]ith the adoption of the [ISDA] protocol by the top 18 
dealer G-SIBs in November, over 90 percent of their OTC bilateral 
trading activity will be covered by stays of either a contractual or 
statutory nature.'' \56\ The FDIC and the Federal Reserve described the 
ISDA Protocol as ``an important step toward mitigating the financial 
stability risks associated with the early termination of bilateral, OTC 
derivatives contracts triggered by the failure of a global banking firm 
with significant cross-border derivatives activities.'' \57\
---------------------------------------------------------------------------
     \54\ The adhering U.S. G-SIBs are Bank of America, Citigroup, 
Goldman Sachs, JPMorgan Chase, and Morgan Stanley. See ISDA Press 
Release (Oct. 11, 2014).
     \55\ The adhering non-U.S. G-SIBs Are Bank of Tokyo-Mitsubishi 
UFJ, Barclays, BNP Paribas, Credit Agricole, Credit Suisse, Deutsche 
Bank, HSBC, Mizuho Financial Group, Nomura, Royal Bank of Scotland, 
Societe Generale, Sumitomo Mitsui Financial Group, and UBS. Id.
     \56\ Financial Stability Board, Press Release (October 11, 2014).
     \57\ Federal Reserve and FDIC, Joint Press Release (October 11, 
2014).
---------------------------------------------------------------------------
d. Other Actions
    The U.S. G-SIBs have also made a number of other structural changes 
and taken a number of other actions to make themselves more resolvable 
under the Bankruptcy Code. These include restructuring and other 
actions to ensure the continuity of shared services throughout the 
resolution process, improving operational capabilities, and preserving 
access to financial market utilities. In addition, the U.S. regulatory 
agencies have taken significant actions to improve coordination with 
foreign regulators. \58\
---------------------------------------------------------------------------
     \58\ See Statement of Donald S. Bernstein Before the Subcommittee 
on Regulatory Reform, Commercial and Antitrust Law of the House 
Committee on the Judiciary at 6-7 (July 9, 2015).
---------------------------------------------------------------------------
e. Regulator Recognition
    The regulators have noticed how much progress the U.S. G-SIBs have 
made in making themselves safe to fail under the Bankruptcy Code. FDIC 
Chairman Martin Gruenberg has described the progress as 
transformational and impressive, and perhaps underappreciated. See 
Exhibit I for a representative set of quotes from selected regulators.
5. Role of Bankruptcy Reform in Addressing Too Big To Fail
    While I believe that the actions taken above should make SPoE 
feasible under the existing Bankruptcy Code, bankruptcy reform would 
enhance the ability of the Bankruptcy Code to address too big to fail 
by making four key additions:

    Clarifying that bank holding companies can recapitalize 
        their operating subsidiaries prior to the commencement of 
        bankruptcy proceedings.

    Clarifying that Section 363 of the Bankruptcy Code can be 
        used to transfer the recapitalized operating subsidiaries to a 
        new holding company using a bridge company structure.

    Adding provisions that permit a short stay of close-outs 
        and allow the assumption and preservation of qualified 
        financial contracts, and overriding ipso facto (bankruptcy) 
        defaults or cross-defaults that might impede the resolution 
        process.

    Providing for some form of fully secured liquidity resource 
        that would offer financing to help stabilize the recapitalized 
        firm and prevent fire sales until access to market liquidity 
        returns. \59\
---------------------------------------------------------------------------
     \59\ Id. at 8-9.

    The first two of these features would increase the certainty of 
application of current law to actions that must be taken in connection 
with an SPoE strategy in bankruptcy. \60\
---------------------------------------------------------------------------
     \60\ Id. at 9.
---------------------------------------------------------------------------
    The third of these features currently is being addressed by 
contractual workarounds like the ISDA Protocol, but it would be far 
better if the Bankruptcy Code were amended to include a provision 
similar to Section 210(c)(16) of the Dodd-Frank Act that provides for 
the override of cross-defaults under QFCs in an SPoE resolution under 
the Bankruptcy Code. \61\
---------------------------------------------------------------------------
     \61\ Id.
---------------------------------------------------------------------------
    The last of these features is currently being addressed by the 
substantially increased liquidity reserves on the balance sheets of 
most of the U.S. G-SIBs, though once they have been recapitalized in an 
SPoE resolution, there is no reason why traditional, secured LOLR 
facilities should not be available to nonbankrupt, fully capitalized, 
going concern subsidiaries of the firms. \62\ The availability of such 
liquidity, if properly structured, would involve no risk of loss to 
taxpayers and would help to mitigate any panic run on subsidiary 
liquidity after the holding company commences its bankruptcy 
proceedings. \63\
---------------------------------------------------------------------------
     \62\ Skeel, supra note 7, at 65 (arguing that Congress should 
amend Section 13(3) of the Federal Reserve Act to expressly permit the 
Federal Reserve to make secured liquidity available to a bridge 
financial company and its operating subsidiaries to facilitate an SPoE 
resolution under the Bankruptcy Code).
     \63\ Bernstein, supra note 58, at 9.
---------------------------------------------------------------------------
    Although TPRRA includes most of these features, it contains a 
provision that would prohibit the Federal Reserve from providing 
liquidity to a bridge FHC for the purpose of providing court-approved 
debtor-in-possession financing under the Bankruptcy Code. I believe 
this provision should be deleted. \64\ My view is consistent with the 
position recently taken by the National Bankruptcy Conference (NBC), 
which essentially made the same observation and recommendation. \65\ In 
addition, if TPRRA fails to allow the Federal Reserve to provide 
secured liquidity to a bridge FHC under the Bankruptcy Code, the U.S. 
G-SIBs may be forced to hold more cash and HQLAs than otherwise. This 
will sharply reduce the amount of credit they can make available to the 
market and give them a powerful incentive to hoard liquidity during a 
financial crisis, when it is most needed by the market. \66\ Finally, 
the absence of a Government LOLR facility in a bankruptcy proceeding 
will increase the range of circumstances under which Title II can be 
lawfully invoked. \67\
---------------------------------------------------------------------------
     \64\ Professor Skeel would go a step further and argue that 
Congress should amend Section 13(3) of the Federal Reserve Act to 
expressly authorize the Federal Reserve to provide secured liquidity to 
a bridge financial company and its operating subsidiaries to facilitate 
an SPoE resolution under the Bankruptcy Code. Skeel, supra note 7, at 
65. While I agree with Professor Skeel's view, I believe that it would 
be worth enacting TPRRA even if it does not contain such an express 
authorization.
     \65\ Letter dated June 18, 2015, from the National Bankruptcy 
Conference to the Honorable Tom Marino, Chairman of the House 
Subcommittee on Regulatory Reform, Commercial and Antitrust Law, the 
Honorable Hank Johnson, the Ranking Member of that Committee, the 
Honorable Chuck Grassley, the Chairman of the Senate Committee on the 
Judiciary, and the Honorable Patrick J. Leahy, Ranking Member of that 
Committee (NBC Letter), at 7.
     \66\ Tarullo, supra note 10, at 5-6, 18.
     \67\ Under Section 203(b)(2) of the Dodd-Frank Act, Title II can 
only be lawfully invoked if the resolution of a covered financial 
company under the Bankruptcy Code would have serious adverse effects on 
financial stability in the United States. The resolution of such a 
company under the Bankruptcy Code is more likely to have serious 
adverse effects on U.S. financial stability if the Federal Reserve is 
prohibited from providing secured liquidity to solvent entities at 
appropriate above-market interest rates to facilitate resolution under 
the Bankruptcy Code.
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    TPRRA would also repeal Title II of the Dodd-Frank Act. Largely for 
the reasons stated by the NBC, \68\ I believe this would be 
inadvisable. While I would prefer that a new Chapter 14 be added to the 
Bankruptcy Code to minimize the circumstances under which Title II can 
be lawfully invoked to the bare minimum, \69\ I believe that there is 
value in preserving Title II for several reasons. First, it may be 
necessary to have a provision like Title II to be able to have a 
Government source of back-up secured liquidity in the event of a 
liquidity famine in the market during a future financial crisis. 
Second, there may be certain unforeseeable emergency circumstances that 
would justify a compromise with the rule of law in favor of allowing 
the FDIC to exercise the broad range of discretion granted by Title II, 
which a bankruptcy court does not have under the Bankruptcy Code.
---------------------------------------------------------------------------
     \68\ NBC Letter, supra note 65, at 3-5.
     \69\ See supra note 67.
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    Third, foreign jurisdictions do not have a tradition of 
recapitalizations or reorganizations under their insolvency laws. As a 
result, foreign regulators associate insolvency laws with liquidations, 
not recapitalizations or reorganizations. To provide for 
recapitalizations or reorganizations of financial firms, these foreign 
jurisdictions have created special resolution regimes (SRR) run by 
administrative agencies rather than courts. These SRRs are 
substantially similar to Title II of the Dodd-Frank Act and the bank 
resolution provisions in the Federal Deposit Insurance Act. As a 
result, many foreign regulators have an almost impossible time 
understanding or accepting that an SPoE strategy can be executed 
effectively under the Bankruptcy Code. It is therefore useful to 
preserve Title II to foster cross-border confidence and cooperation in 
the U.S. resolution process. Such confidence and cooperation would 
almost certainly be undermined if Title II were repealed.
Conclusion
    While the U.S. G-SIBs have made substantial progress showing that 
an SPoE strategy can be executed under existing Chapter 11, bankruptcy 
reform has the potential to increase the legal certainty of that 
outcome. Indeed, I believe that the proposed TPRRA would increase the 
ability of the Bankruptcy Code to address too-big-to-fail with two 
modifications. First, the provisions prohibiting the Federal Reserve 
from providing advances to bridge financial companies in a bankruptcy 
proceeding for the purpose of providing it with debtor-in-possession 
financing should be deleted. Second, while it is desirable for TPRRA to 
reduce the circumstances under which Title II of the Dodd-Frank Act can 
be lawfully invoked to the bare minimum, it should not entirely repeal 
Title II.


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                  PREPARED STATEMENT OF JOHN B. TAYLOR
   Hoover Institution Senior Fellow in Economics, Stanford University
                             July 29, 2015
    Chairman Toomey, Ranking Member Merkley, and other Members of the 
Subcommittee on Financial Institutions and Consumer Protection, I thank 
you for the opportunity to testify at this important hearing on ``The 
Role of Bankruptcy Reform in Addressing Too Big To Fail''. \1\
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     \1\ Mary and Robert Raymond Professor of Economics at Stanford 
University, George P. Shultz Senior Fellow in Economics at Stanford's 
Hoover Institution, and former Under Secretary of Treasury for 
International Affairs, 2001-2005. I am most grateful to Emily Kapur for 
advice and suggestions in preparing this testimony which draws directly 
from her research on how a Chapter 14 reform of the bankruptcy code 
would work in practice.
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    Bankruptcy reform is essential to addressing the problem of too big 
to fail. A well-designed reform that handles large financial firms and 
makes failure feasible under clear rules without disruptive spillovers 
would greatly reduce the likelihood of Government bailouts. It would 
thereby diminish excessive risk-taking, remove uncertainty due to an 
inherently ad hoc bailout process, and cut the implicit subsidy to 
``too big to fail'' firms.
    In the 7 years since the financial crisis, much economic research 
and legal analysis has been devoted to finding the best way to proceed 
with bankruptcy reform. \2\ And good reform bills have now been 
introduced in the Senate, ``The Taxpayer Protection and Responsible 
Resolution Act'' (TPRRA) and in the House, ``The Financial Institution 
Bankruptcy Act of 2015''.
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     \2\ See, for example, the work of the Resolution Project at 
Stanford University's Hoover Institution in the books by Scott, 
Jackson, and Taylor (2015), Scott and Taylor (2012), Scott, Shultz, and 
Taylor (2010), the Bipartisan Policy Center report by Jackson, Guynn, 
and Bovenzi (2013), the Cleveland Fed study by Fitzpatrick and Thomson 
(2011), the Board of Governors of the Federal Reserve (2011), and 
Government Accountability Office (2011).
---------------------------------------------------------------------------
Current Bankruptcy Law and the Failure of Large, Complex Financial 
        Institutions
    Under current bankruptcy law, a failing firm can be reorganized 
under a Chapter 11 proceeding in which losses are calculated according 
to prescribed and open procedures, known in advance. If the failed 
firm's liabilities exceed its assets, then the shareholders are wiped 
out. The remaining difference between liabilities and assets is then 
allocated among creditors in the order of priority stipulated by the 
law, which is also known in advance. The creditors' debts are written 
down and, sometimes, converted into equity in the reorganized firm. In 
the end, the firm continues in business with either the old or new 
managers. Chapter 11 ensures that creditors bear losses and this 
reduces moral hazard and excessive risk-taking.
    Thus, Chapter 11 has many benefits. However, Chapter 11 is designed 
as a general procedure for a wide variety of businesses. Large complex 
financial institutions present special considerations which warrant a 
reform of the bankruptcy code. The existing bankruptcy process is 
likely to be too slow for the fast moving markets that these types of 
firms deal in. The bankruptcy judges might not have enough financial 
experience to understand the market implications of their judicial 
decisions. Many exceptions to bankruptcy (for example, for brokerage 
and insurance companies) also complicate Chapter 11 proceedings for 
large multiproduct financial firms.
    Perhaps most importantly, under Chapter 11 it is difficult to 
maintain adequately the operations of a large complex financial 
institution that is failing in ways that will prevent a run. Because of 
Government policymakers' concerns about the systemic consequences of 
such a run, use either Title II of the Dodd-Frank Act or a direct 
bailout.
    Concerns over the experience with Lehman Brothers' Chapter 11 may 
make it more likely in the future that creditors would run before a 
Chapter 11 proceeding and that policymakers would therefore resort to 
Title II or a bailout. In the case of Lehman, losses were allocated to 
short-term unsecured creditors that had continued to fund Lehman 
because they expected its treatment to be similar to Bear Stearns' 
bailout. Even if these concerns are unwarranted, they lead market 
participants to expect that Chapter 11 will not be used.
Bankruptcy Reform for More Credible Resolutions Through Bankruptcy Law
    To deal with these shortcomings, a reform of the bankruptcy code is 
needed with a new chapter or subchapters along the lines of the Chapter 
14 proposal in the Taxpayer Protection and Responsible Resolution Act 
\3\ or the Subchapter V of Chapter 11 proposal in the Financial 
Institution Bankruptcy Act of 2015. Under such a reform the procedures 
to determine asset values, liabilities, sales of some lines of 
business, write-downs of claims, and recapitalization would be based on 
the rule of law, as under Chapter 11, and the strict priority rules of 
bankruptcy would govern. Thus, the resolution regime under bankruptcy 
would ensure that any failing institution would be resolved through the 
same known set of processes. One of the biggest problems in the 2008 
panic was a lack of predictability, with the Government applying widely 
varying policies.
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     \3\ After first using the term Chapter 11F in Scott, Shultz, and 
Taylor (2010), the Resolution Project at Stanford's Hoover Institution 
adopted the term Chapter 14 in Scott and Taylor (2012) because there is 
currently no such numbered chapter in the code. Here I use the term 
Chapter 14 to refer to this type of bankruptcy reform.
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    Unlike reorganization under Chapter 11, however, the Chapter 14 
proceedings would be overseen by a specialized panel of Article III 
judges and special masters with financial expertise. The bankruptcy 
would involve only a single proceeding, unlike current law where a 
parent company must go through one proceeding and insurance and 
brokerage subsidiaries through another, adding considerable complexity.
    Chapter 14 would operate faster--ideally over a weekend--and with 
no less precision than Chapter 11. Unlike Chapter 11, it would leave 
all operating subsidiaries outside of bankruptcy entirely. It would do 
this by moving the original financial firm's operations to a new bridge 
company that is not in bankruptcy. This bridge company would be 
recapitalized by leaving behind long-term unsecured debt--called the 
``capital structure debt.'' The firm's long-term unsecured debt would 
bear the losses due to the firm's insolvency and any other costs 
associated with bankruptcy. If the amount of long-term debt and 
subordinated debt were sufficient, short-term lenders would not have an 
incentive to run, and the expectation of Chapter 14's use will reduce 
ex ante uncertainty about runs.
    The goal of these provisions is to let a failing financial firm go 
into bankruptcy in a predictable, rules-based manner without causing 
disruptive spillovers in the economy while permitting people to 
continue to use its financial services without running. The net effect 
is similar to well-known bankruptcy cases for nonfinancial firms in 
which people could continue to fly on American Airlines planes, buy 
Kmart sundries and try on Hartmax suits. The provisions make it 
possible to create a new fully capitalized entity which would credibly 
provide most of the financial services the failed firm was providing 
before it got into trouble. Modularization of the firm, which is in 
principle made easier by the living wills, would expedite the process.
    The new Chapter 14 would also allow the primary Federal regulator 
of the firm to file a bankruptcy petition in addition to creditors and 
management. This would expedite the process, especially in cases where 
management, fearing a loss of equity or employment, has incentives to 
put off a filing. The examiner's report on Lehman makes it very clear 
there was no preparation for bankruptcy proceedings before the 
bankruptcy filing, which increased the size of the disruption.
    To understand how such a reformed bankruptcy code would resolve a 
large and complex financial institution, it is very useful to consider 
how Chapter 14 would have worked in the case of Lehman Brothers in 
2008. Emily Kapur (2015) has carefully researched such a scenario using 
balance sheet and financial data that has been made public through 
Lehman's court proceedings, and has prepared a brief and illustrative 
summary which appears at the end of this testimony.
Bankruptcy Reform and More Robust Resolution Planning Under the Dodd-
        Frank Act
    The Dodd-Frank Act requires that resolution plans--living wills--be 
submitted by the large and complex financial firms to show how these 
firms can be resolved in cases of distress or failure in a rapid and 
orderly resolution without systemic spillovers under existing law. Of 
course, existing law includes Chapter 11 of the bankruptcy code.
    Thus far the plans submitted by the large financial firms have been 
rejected by the Federal Reserve and the Federal Deposit Insurance 
Corporation (FDIC). The reasons for the rejections are not fully known, 
but clearly the requirement that the firms would have to go through a 
Chapter 11 bankruptcy is an impediment as I explained in the first 
section of this testimony: it is very difficult, if not impossible, at 
this time to bring one of these large firms through a conventional 
Chapter 11 bankruptcy.
    William Kroener (2015) points out, however, that a Chapter 14 
reform would greatly facilitate the resolutions plans' ability to meet 
the statutory requirements. Unlike Chapter 11, it would leave all 
operating subsidiaries outside of bankruptcy entirely as these 
subsidiaries move to the new firm that is not in bankruptcy. In other 
words, bankruptcy reform would help greatly in the resolution planning 
process required in the Dodd-Frank Act.
Shortcomings of the FDIC Resolution Mechanism Under Title II of the 
        Dodd-Frank Act
    While full liquidation with wiped-out shareholders was a major 
selling point of the Dodd-Frank Act, \4\ in the years since the Act was 
passed the focus of the FDIC has been on how to resolve and reorganize 
the failing firm into an ongoing concern, rather than on how to 
liquidate it. To achieve such a re-organization under this new 
authority the FDIC would transfer part of a failing firm's balance 
sheet and its operations to a new bridge institution.
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     \4\ This section is based on Taylor (2013).
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    In order to carry out this task, the FDIC would have to exercise 
considerable discretion. The degree of discretion would be especially 
large in comparison with more transparent and less uncertain bankruptcy 
proceedings through which nonfinancial firms are regularly resolved and 
reorganized through the rules of the bankruptcy laws. As a result there 
is confusion about how the reorganization process would operate under 
Title II, especially in the case of international firms. Indeed, this 
uncertainty about the Title II process would likely lead policymakers 
to ignore it in the heat of a crisis and resort to massive taxpayer 
bailouts as in the past. Hence, the concern about bailouts remains.
    But even if the Title II process were used, bailouts would be 
likely. As the FDIC exercised its discretion to form a bridge bank, it 
would likely give some creditors more funds than they would have 
expected or been entitled to under bankruptcy law. They might wish to 
hold some creditors harmless, or nearly harmless, in order to prevent a 
perceived contagion of the firm's failure to other parts of the 
financial system. This action would violate the priority rules that 
underlie everyday decisions about borrowing and lending. Under the 
reasonable definition that bailout means that some creditors get more 
than they would under bankruptcy laws or under the normal workings of 
the market, such action would, by definition, be a bailout of the 
favored creditors.
    This expectation of bailout of some creditors increases the risk of 
financial instability. Government regulation through capital or 
liquidity requirements and supervision is not the only way a financial 
firm's risk-taking decisions are constrained. Discipline is also 
imposed on the firm by its counterparties, so long as they perceive a 
need to monitor the firm and protect themselves from losses by 
demanding collateral or simply cutting off credit. Creditors have 
significant advantages over Government regulators, in terms of current 
knowledge, ability to act quickly, and financial stakes. And they are 
not subject to regulatory capture.
    The expectation of bailouts of creditors weakens the incentives for 
them to monitor their loans and thereby provide this constraint on risk 
taking. Because the bailout reduces the risk incurred by large 
creditors expecting to be favored, they charge a lower interest rate, 
creating the subsidy of large and complex financial firms.
    It is important to recognize that the perverse effects of such 
bailouts occur whether or not the source of the extra payment comes 
from the Treasury financed by taxpayers, from an assessment fund 
financed by financial institutions and their customers, or from smaller 
payments for less favored creditors.
    Contrasting the resolution of a failing financial firm under Title 
II with resolution under a reformed bankruptcy procedure reveals 
additional concerns with Title II. Under bankruptcy reorganization, 
private parties, motivated and incentivized by profit and loss 
considerations, make key decisions about the direction of the new firm, 
perhaps subject to bankruptcy court oversight. But under Title II a 
Government agency, the FDIC and its bridge bank, would make the 
decisions. This creates the possibility that the FDIC would be 
pressured to ask the bridge firm to grant special favors to certain 
creditors as in the case of the Government Sponsored Enterprises.
    In addition, the resolution of a firm through a Government-
administered bridge company could give the new firm advantages over its 
competitors in comparison with a bankruptcy resolution. The Treasury is 
authorized to fund the FDIC which can fund the bridge firm, creating a 
subsidy, and under Title II the bridge firm can be given lower capital 
requirements and forgiven tax liabilities.
    One can understand that the FDIC or any Government agency in charge 
of resolutions would want to use such legal provisions to nurse the 
bridge firm with special advantages for a while before letting it 
compete on a level playing field. But with a large amount of discretion 
and strong incentives to make the resolved firm a success, there is a 
concern that the advantages granted by a Government agency could become 
excessive and prolonged.
Summary
    In this testimony I showed why a reform of the bankruptcy law along 
the lines of the Senate bill, ``The Taxpayer Protection and Responsible 
Resolution Act'' (TPRRA) or the House bill, ``The Financial Institution 
Bankruptcy Act of 2015'' is essential for ending Government bailouts as 
we know them. Such a reform--which would make failure feasible even for 
large and complex financial institutions--would play a key role in 
addressing the problems of excess risk taking, uncertainty, and unfair 
subsidies associated with too big to fail, which persist under the 
Dodd-Frank Act. If accompanied with an increase in capital and capital 
structure debt, such a reform would go a long way toward ending too big 
too fail.
    If Title II of the Dodd-Frank Act remains in the law, such a reform 
would likely reduce the use of Title II, and thus lead to more rules-
based and less discretionary resolutions. The reform would also repair 
the resolution planning process now required under the Dodd-Frank Act.


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                PREPARED STATEMENT OF THOMAS H. JACKSON
              President Emeritus, University of Rochester
                             July 29, 2015
    Thank you for inviting me to testify today. I am Thomas Jackson, 
Distinguished University Professor and President Emeritus at the 
University of Rochester. Prior to moving to the University of 
Rochester, I was a professor of law, specializing in bankruptcy, at 
Stanford, Harvard, and the University of Virginia schools of law. I am 
the author of a Harvard Press book, The Logic and Limits of Bankruptcy 
Law, a bankruptcy casebook, and numerous articles on bankruptcy law. 
Recently, my work in the field of bankruptcy has focused on the use of 
bankruptcy in resolving systemically important financial institutions 
(SIFIs). In that capacity, I was cochair of a Bipartisan Policy Center 
working group that produced, in May of 2013, Too Big To Fail: The Path 
to a Solution. I have also been, since 2008, a member of the Hoover 
Institution's Resolution Project, which has produced three books 
discussing how bankruptcy can be made more effective in terms of the 
resolution of SIFIs (the most recent one, Making Failure Feasible, is 
in the final publication process). And, since 2013, I have been a 
member of the Federal Deposit Insurance Corporation's (FDIC's) Systemic 
Resolution Advisory Committee. I am here today in my individual 
capacity, and the views I express are my own, not those of any group or 
organization with which I am affiliated.
    I am a firm believer that the Bankruptcy Code, with a few 
significant changes, can be made an important player in the resolution 
of SIFIs and that both bankruptcy law and the Dodd-Frank Act can be 
made more effective as a result. Before discussing those changes, 
however, I believe it is important to set out, briefly, (a) the 
relationship envisioned between the Dodd-Frank Act and bankruptcy law, 
(b) the current status of the major alternative to bankruptcy--the 
Orderly Liquidation Authority (OLA) of Title II of the Dodd-Frank Act, 
(c) why bankruptcy law, without statutory changes, is likely to be 
inadequate in terms of fulfilling what virtually everyone believes 
should be its role, and (d) why this creates problems both for the 
Dodd-Frank Act's Title I provisions for resolution plans under Section 
165(d)--so-called ``Living Wills''--as well as for its OLA provisions 
under Title II. After setting out that important backdrop, I will 
discuss, at a somewhat abstract level, the core of changes that I would 
suggest be implemented in the Bankruptcy Code in order to make it the 
primary resolution mechanism, even in light of the FDIC's development 
of ``single-point-of-entry'' (SPoE) as its presumptive method of 
implementing OLA under Title II of the Dodd-Frank Act, thus fulfilling 
the intent of both Title I and Title II of that Act. A full set of 
changes I might recommend--including provisions that might be ``nice 
but not necessary''--is discussed in my contribution to Making Failure 
Feasible, a copy of which is attached to this Statement as an Appendix.
The Relationship Envisioned Between the Dodd-Frank Act and Bankruptcy 
        Law
    In two key places, the Dodd-Frank Act envisions bankruptcy as the 
preferred mechanism for the resolution of SIFIs. The first occurs in 
Title I, with the provision for resolution plans under Section 165(d). 
Covered financial institutions are required to prepare, for review by 
the Board of Governors of the Federal Reserve System (Federal Reserve 
Board or FRB), the Financial Stability Oversight Council, and the FDIC, 
``the plan of such company for rapid and orderly resolution in the 
event of material financial distress or failure . . . .'' \1\ If the 
Federal Reserve Board and the FDIC jointly determine that a submitted 
resolution plan ``is not credible or would not facilitate an orderly 
resolution of the company under Title 11, United States Code'' (i.e., 
the Bankruptcy Code), the company needs to resubmit a plan ``with 
revisions demonstrating that the plan is credible, and would result in 
an orderly resolution under title 11, United States Code . . . .'' \2\ 
The failure to submit a plan that meets these tests can lead to 
restrictions, and divestiture, ``in order to facilitate an orderly 
resolution of such company under title 11, United States Code . . . .'' 
\3\ For present purposes, the important point is that effective 
resolution plans are tested against bankruptcy law, not OLA under Title 
II of the Dodd-Frank Act. It therefore goes without saying--but is 
worth saying nonetheless--that the effectiveness of bankruptcy law in 
being able to resolve SIFIs is critically important to the development 
of credible resolution plans under Title I. \4\
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     \1\ Dodd-Frank Act 165(d)(1).
     \2\ Dodd-Frank Act, 165(d)(4)
     \3\ Dodd-Frank Act, 165(d)(5)(A) and (B).
     \4\ See William F. Kroener III, Revised Chapter 14 ``2.0 and 
Living Will Requirements Under the Dodd-Frank Act'', in Kenneth E. 
Scott, Thomas H. Jackson, and John B. Taylor (eds.), Making Failure 
Feasible: How Bankruptcy Reform Can End ``Too Big To Fail'' (Hoover 
Institution Press 2015).
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    Indeed, first-round resolution plans were uniformly rejected as 
inadequate. The eight U.S. Global Systemically Important Banks (G-SIBs) 
filed revised plans within the past month; most of them propose a SPoE 
resolution strategy, keyed off of the FDIC's work for resolution under 
the Dodd-Frank Act's Title II OLA, and which, in my view, would be 
awkwardly implemented--perhaps not impossible, but difficult--under 
today's Bankruptcy Code, for reasons I will discuss.
    The second occurs in the context of the ability to initiate the OLA 
process under Title II of the Dodd-Frank Act. Invocation of Title II 
itself can only occur if the Government regulators find that bankruptcy 
is wanting. \5\ That is, by its own terms, bankruptcy is designed by 
the Dodd-Frank Act to be the preferred resolution mechanism. \6\ The 
FDIC has announced that it supports the idea that bankruptcy, not OLA, 
should be the presumptive resolution procedure. \7\ The ability of 
bankruptcy law to fulfill its intended role as the presumptive 
procedure for resolution, of course, turns on the effectiveness of 
bankruptcy law in rising to the challenge of accomplishing a resolution 
that meets three important goals: One that (a) both minimizes losses 
and places them on appropriate, pre-identified, parties, (b) minimizes 
systemic consequences; and (c) does not result in a Government bail-
out. (In many ways, (c) is actually a direct consequence of (a): If 
losses are borne by appropriate, pre-identified, parties, the 
Government does not need to absorb losses via a bail-out.) The goal 
should be resolution within these constraints, not necessarily an 
inefficient liquidation--a goal wholly consistent with that of Chapter 
11 of the Bankruptcy Code. \8\
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     \5\ Dodd-Frank Act, 203(a)(1)(F) and (a)(2)(F); 203(b)(2) and 
(3).
     \6\ Federal Deposit Insurance Corporation, ``The Resolution of 
Systemically Important Financial Institutions: The Single Point of 
Entry Strategy'', 78 Fed. Reg. 76614 (Dec. 18, 2013) (hereafter ``FDIC 
SPoE''), at 76615 (``the statute makes clear that bankruptcy is the 
preferred resolution framework in the event of the failure of a 
SIFI''); see Statement of Martin J. Gruenberg, Chairman, Federal 
Deposit Insurance Corporation on Implementation of the Dodd-Frank Act 
before the Committee on Banking, Housing, and Urban Affairs, United 
States Senate (December 6, 2011), available at http://www.fdic.gov/
news/news/speeches/chairman/spdec0611.html (``If the firms are 
successful in their resolution planning, then the OLA would only be 
used in the rare instance where resolution under the Bankruptcy Code 
would have serious adverse effects on U.S. financial stability'').
     \7\ See Remarks by Martin J. Gruenberg, Chairman, Federal Deposit 
Insurance Corporation, in Implementation of the Dodd-Frank Act before 
the Volcker Alliance Program (October 13, 2013), available at http://
www.fdic/gov/news/news/speeches/spoet1313.html.
     \8\ There is a separate question--that I do not address (as it is 
not my area of expertise)--as to whether several financial institutions 
are simply ``too big.'' I strongly urge that question be addressed 
directly--and separately. Bankruptcy law should efficiently resolve 
(through reorganization, recapitalization, sale, or liquidation) the 
entities, including financial institutions, that use it. It should not 
include a policy--that would be inconsistent with long-standing 
bankruptcy policy--favoring liquidation simply based on size.
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The Current Status of the Orderly Liquidation Authority
    Title II of the Dodd-Frank Act, containing the OLA, in many ways 
adopts many of bankruptcy law's provisions, with a key difference being 
that the resolution is handled by the FDIC, as receiver, retaining 
significant discretion, as compared to a bankruptcy court, subject to 
statutory rules that can and will be enforced by appellate review 
through the Article III judicial system.
    But we are not in 2010, when the Dodd-Frank Act was envisioned and 
enacted. Much thinking and work has occurred since then, in terms of 
how, effectively, to resolve a SIFI without jeopardizing the financial 
system and without a Government bailout. Increasingly, attention has 
turned, in Europe as well as in the United States, on a rapid 
recapitalization. Europe has focused on a ``one-entity'' 
recapitalization via bail-in \9\ while the FDIC has focused, in its 
SPoE proposal, on a ``two-entity'' recapitalization rather than a 
formal bail-in. \10\ Under the FDIC's approach, \11\ a SIFI holding 
company (the ``single point of entry'') is effectively 
``recapitalized'' over a matter of days, if not hours, by the transfer 
of virtually all its assets and liabilities, except for certain long-
term unsecured liabilities, to a new bridge institution whose capital 
structure, because of the absence of those long-term unsecured 
liabilities, is both different and presumptively ``sound.'' Because of 
the splitting off of the long-term unsecured debt, the bridge 
institution, in the FDIC's model, looks very much like a SIFI following 
a European-like ``bail in.'' The major difference is that in the ``bail 
in,'' the SIFI holding company before and after the recapitalization is 
the same legal entity (thus, the ``one-entity'' recapitalization), 
whereas in the FDIC's SPoE proposal, the ``recapitalized'' bridge 
institution, a different legal entity, is formed first and effectively 
receives a ``new'' capital structure by virtue of having long-term 
unsecured debt left behind in the transfer to it and the bridge 
institution, in turn, recapitalizes (where necessary) its operating 
subsidiaries (thus, the ``two-entity'' recapitalization) \12\ In both 
cases, the resulting holding company then forgives intercompany 
liabilities or contributes assets to recapitalize its operating 
subsidiaries.
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     \9\ Financial Stability Board, ``Progress and Next Steps Towards 
Ending `Too Big To Fail','' Report of the Financial Stability Board to 
the G20, available at www.financialstabilityboard.org/publications/
r_130902.pdf (Sept. 2013); Thomas Huertas, Vice Chairman, Comm. of 
European Banking Supervisors and Dir., Banking Sector, U.K. Fin. 
Services Auth., ``The Road to Better Resolution: From Bail-Out to Bail-
In'', speech at The Euro and the Financial Crisis Conference (Sept. 6, 
2010), available at http://www.fsa.gov.uk/library/communication/
speeches/2010/0906_th.shtml; Clifford Chance, ``Legal Aspects of Bank 
Bail-Ins'' (2011).
     \10\ FDIC SPoE, supra note 6. See Federal Deposit Insurance 
Corporation and Bank of England, Joint Paper, ``Resolving Globally 
Active, Systemically Important, Financial Institutions'' (Dec. 10, 
2012), available at http://www.bankofengland.co.uk/publications/
Documents/news/2012/nr156.pdf (jointly proposing the single-point-of-
entry approach).
     \11\ Early signs of which were foreshadowed in Randall Guynn, 
``Are Bailouts Inevitable?'' 29 Yale J. On Regulation 121 (2012).
     \12\ In part, this difference is driven by different 
organizational structures common to U.S. SIFI's versus European SIFIs--
our SIFIs are much more likely to use a holding company structure; in 
part this difference is driven by Title II's liquidation ``mandate.'' 
Section 214(a) of the Dodd-Frank Act explicitly states: ``All financial 
companies put into receivership under this subchapter shall be 
liquidated.'' As a bankruptcy scholar, I view this latter mandate, at 
least in the abstract, as unfortunate. A first-day lesson in a 
corporate reorganization course is that ``understanding that financial 
and economic distress are conceptually distinct from each other is 
fundamental to understanding Chapter 11 of the Bankruptcy Code,'' Barry 
Adler, Douglas Baird, and Thomas Jackson, ``Bankruptcy: Cases, 
Problems, and Materials'' 28 (Foundation Press 4th ed. 2007). Avoiding 
a bailout requires that losses be borne by appropriate parties, 
identified in advance, not necessarily by liquidation of the underlying 
business, which may cause an unnecessary destruction of value. The 
FDIC's SPoE strategy formally complies with the statutory requirement, 
by liquidating the SIFI holding company after its assets have been 
liquidated via the transfer to the bridge company.
---------------------------------------------------------------------------
    There are preconditions for making this work. Important among them 
are legal rules, known in advance, setting forth a required amount of 
long-term debt (or subordinate or bail-in debt) to be held by the SIFI 
that would be legally subordinate to other unsecured debt--in the sense 
of its debt-holders knowing that this debt would be ``bailed-in'' (in a 
one-entity recapitalization) or left behind (in a two-entity 
recapitalization). \13\ Much work has been done on this dimension, both 
under Basel III and through the Federal Reserve Board's Comprehensive 
Capital Analysis and Review (CCAR). \14\ And the effective use of a 
two-entity recapitalization in Title II of the Dodd-Frank Act needs to 
straddle the tension between Title II's liquidation mandate (literally 
met because, following the transfer to the bridge company, the assets 
of the original holding company will have been removed from the SIFI 
holding company, which will subsequently itself be liquidated) and the 
notion of limiting financial contagion and using Title II only when its 
invocation is required because of serious doubts about the 
effectiveness of the use of the bankruptcy process. That said, many 
recognize that the FDIC's SPoE proposal for Title II of the Dodd-Frank 
Act, consistent with parallel work in Europe, is a significant 
development in terms of advancing the goals of avoiding ``too big to 
fail''--a resolution process that (a) allocates losses among the 
appropriate parties, (b) limits systemic consequences, and (c) avoids a 
Government-funded bail-out. \15\
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     \13\ See John Bovenzi, Randall Guynn, and Thomas Jackson, ``Too 
Big To Fail: The Path to a Solution'' (Bipartisan Policy Center, 
Failure Resolution Task Force May 2013).
     \14\ www.federalreserve.gov/bankinforog/ccar.htm
     \15\ See Daniel Tarullo, ``Toward Building a More Effective 
Resolution Regime: Progress and Challenges'' (Oct. 2013), available at 
http://www.federalreserve.gov/newsevents/speech/tarullo20131018a.html 
(``The single-point-of-entry approach offers the best potential for the 
orderly resolution of a systemic financial firm . . . ''); William 
Dudley, President and Chief Executive Officer, Federal Reserve Bank of 
New York, Remarks at the Federal Reserve Board and Federal Reserve Bank 
of Richmond Conference, ``Planning for the Orderly Resolution of a 
Globally Systemically Important Bank, p.1 (Wash. DC, Oct. 18, 2013) 
(``I very much endorse the single-point-of-entry framework for 
resolution as proposed by the Federal Deposit Insurance Corporation 
(FDIC).''); John Bovenzi, Randall Guynn, and Thomas Jackson, supra note 
13; David Skeel, ``Single Point of Entry and the Bankruptcy 
Alternative'', in Martin Neil Baily and John B. Taylor (eds.), ``Across 
the Great Divide: New Perspectives on the Financial Crisis'' (Hoover 
Press 2014).
---------------------------------------------------------------------------
    Title II's OLA provisions, however, also come with certain defects. 
The FDIC retains discretion to prefer some creditors over others of 
equal rank, without limiting it to occasions where there is background 
legal authority (which will rarely occur at the holding company level), 
and at important points the FDIC, rather than the market, is making 
critical determinations regarding the bridge financial company and its 
equity. \16\ Thus, the FDIC proposes that the bridge financial 
institution created in the SPoE process (treated as a Government entity 
for tax purposes \17\) is effectively run, for a while at least, by the 
FDIC. \18\ In addition, the FDIC's SPoE proposal relies on expert (and 
FDIC) valuations of the new securities that will form the basis of the 
distribution to the long-term creditors and old equity interests ``left 
behind,'' \19\ and the FDIC retains the authority to distribute them 
other than according to the absolute priority rule so well known in 
bankruptcy law. \20\
---------------------------------------------------------------------------
     \16\ See FDIC SPoE, supra note 6, 76616-18.
     \17\ Dodd-Frank Act, section 210(h)(1) (``a bridge financial 
company . . . shall be exempt from all taxation now or hereafter 
imposed by the United States, by any territory, dependency, or 
possession thereof, or by any State, county, municipality, or local 
taxing authority'').
     \18\ FDIC SPoE, supra note 6, 76617.
     \19\ FDIC SPoE, supra note 6, 76618.
     \20\ FDIC SPoE, supra note 6, 76619.
---------------------------------------------------------------------------
    In addition, the FDIC's SPoE proposal is, itself, potentially 
limited in scope:

        The FDIC's SPoE bridge proposal seemingly applies only to 
        domestic financial companies posing systemic risk (currently, 
        eight bank and three or four nonbank holding companies are so 
        regarded, although more may be added, even at the last minute), 
        not to the next hundred or so bank holding companies with more 
        than $10 billion in consolidated assets, or to all the 
        (potentially over one thousand) ``financial companies'' covered 
        by Dodd-Frank's Title I definition (at least 85 percent of 
        assets or revenues from financial activities). \21\
---------------------------------------------------------------------------
     \21\ Kenneth Scott, ``The Context for Bankruptcy Resolutions'', in 
Kenneth E. Scott, Thomas H. Jackson, and John B. Taylor (eds.), supra 
note 4, at 5-6.
---------------------------------------------------------------------------
The Inadequacies of Current Bankruptcy Law Seen in Light of SPoE
    I believe the ``bones'' for a comparably successful resolution of a 
SIFI under the Bankruptcy Code are already in place. But, without 
statutory revisions, such as I will be addressing in this Statement, 
those ``bones'' are unlikely to translate to a competitive resolution 
procedure to SPoE, as developed by the FDIC, under Title II of the 
Dodd-Frank Act.
    While it is probably the case that the original ``intent'' of 
Section 363 of the Bankruptcy Code--a provision providing for the use, 
sale, and lease of property of the estate--at the time of its enactment 
in 1978 was to permit piecemeal sales of unwanted property, Chapter 11 
practice began, over time, to move in the direction of both (a) pre-
packaged plans of reorganization and (b) procedures whose essential 
device was a going-concern sale of some or all of the business (whether 
prior to or in connection with a plan of reorganization), leaving the 
original equity and much of the debt behind and with the proceeds of 
the sale forming the basis of the distribution to them according to the 
plan of reorganization and bankruptcy's priority rules. \22\ While 
these going-concern sales don't fit perfectly with the original vision, 
which assumed the Chapter 11 company would be reorganized, not sold, 
such sales have been used, repeatedly, as a way of continuing a 
business outside of bankruptcy while the claimants and equity 
interests, left behind, wind up as the owners of whatever was received 
by the bankruptcy estate in connection with the sale. And it, at least 
in rough contours, has structural features in common with the two-step 
recapitalization that is envisioned under the FDIC's SPoE procedure.
---------------------------------------------------------------------------
     \22\ David Skeel, ``Debt's Dominion: A History of Bankruptcy Law 
in America'' 227 (Princeton 2001); Barry Adler, Douglas Baird, and 
Thomas Jackson, supra note 12, at 466-467 (``between [1983 and 2003] a 
sea change occurred through which an auction of the debtor's assets has 
become a commonplace alternative to a traditional corporate 
reorganization'').
---------------------------------------------------------------------------
    That said, a Section 363 sale is an imperfect competitor to SPoE in 
its current form. While both will require identification of long-term 
debt (or capital structure debt) that will be left behind--again, work 
that is well underway \23\--a successful two-entity recapitalization 
essentially requires the bridge company to be able to acquire all of 
the remaining assets, contracts, permits, rights, and liabilities of 
the SIFI holding company, while preserving the businesses of the 
transferred, nonbankrupt, operating subsidiaries.
---------------------------------------------------------------------------
     \23\ See text accompanying notes 8-15, supra.
---------------------------------------------------------------------------
    That seems to me very difficult to accomplish under the current 
Bankruptcy Code. First, because of a series of amendments designed to 
insulate qualified financial contracts--swaps, derivatives, and repos--
from many of bankruptcy's provisions, most notably the automatic stay 
and the unenforceability of ipso facto clauses, there is no effective 
mechanism in the current Bankruptcy Code to preclude counterparties on 
qualified financial contracts from running upon the commencement of a 
bankruptcy case. \24\ Importantly, even if most such contracts reside 
in nonbankrupt operating subsidiaries of the bridge company, such 
creditors may have cross-default or change-of-control provisions 
triggered by the Chapter 11 filing of their former holding company. (As 
a result of a dialogue with regulators sensitive to this problem in 
resolution proposals outside of bankruptcy, a major step in ``solving'' 
this concern--at least for adhering parties (initially, the 18 largest 
dealer banks)--occurred with the International Swaps and Derivatives 
Association's (ISDA's) 2014 Resolution Stay Protocol. \25\) Nor would 
it be clear under existing bankruptcy law that operating licenses, 
permits, and the like could be transferred to the bridge company, 
either because it legally is a new company or because there has been a 
change of control of the holding company and its operating subsidiaries 
in derogation of change-of-control provisions or requirements 
applicable to individual entities. \26\
---------------------------------------------------------------------------
     \24\ Bankruptcy Code 362(b)(6), (7), (17), (27), 546(e), (f), 
(g), (j), 555, 556, 559, 560, 561. (The FDIC SPoE proposal, consistent 
with statutory authorization, Dodd-Frank Act 210(c)(8), (9), (10), 
(16), will override any such provisions in counterparty contracts (and 
subsidiary cross-default provisions); bankruptcy, being a judicial 
proceeding, cannot (and should not) do that without comparable 
statutory authorization which currently not only is missing but is 
expressly contradicted by provisions that exist.) While my statement 
today focuses on changes that are necessary in these existing 
protective provisions for counterparties on qualified financial 
contracts in the Bankruptcy Code in order to permit an effective two-
step recapitalization of a SIFI holding company, I believe these 
existing Bankruptcy Code provisions, and their relationship to 
bankruptcy law more generally, needs to be rethought. See David Skeel 
and Thomas Jackson, ``Transaction Consistency and the New Finance in 
Bankruptcy'', 112 Colum. L. Rev. 152 (2012).
     \25\ See ISDA, ``Resolution Stay Protocol--Background'', October 
11, 2014; see also Tom Braithwaite and Tracy Allway, ``Banks Rewrite 
Derivative Rules To Cope With Future Crisis'', Financial Times, October 
7, 2014.
     \26\ Many of these will not be executory contracts, subject to the 
assumption and assignment provisions of 365 of the Bankruptcy Code. 
Nor does the current Bankruptcy Code directly deal, apart from those 
provisions, with change-of-control triggers in licenses and the like.
---------------------------------------------------------------------------
    Moreover, while the Bankruptcy Code clearly contemplates an ability 
to move with necessary speed, including when a provision calls for a 
notice and hearing before any decision (such as under Section 363(b)), 
\27\ the lack of clear statutory authority for a very rapid transfer to 
a bridge company may leave too much--for the comfort of a SIFI or a 
regulatory body--up to the discretion of a particular judge who first 
gets a SIFI holding company requesting such a transfer. Nor is there a 
clear necessity for notice to, or hearing by, a Government regulator--
whether the FDIC or Federal Reserve Board, in the case of the holding 
company, or a foreign regulator, in the case of a foreign subsidiary 
that is proposed to be transferred to a bridge company. These 
uncertainties, even with a robust resolution plan, may inspire enough 
lack of confidence by the FDIC and the Federal Reserve Board so as to 
view the commencement of an OLA proceeding under Title II of the Dodd-
Frank Act to be the preferable course--or, alternatively, lack of 
sufficient confidence by foreign regulators so as to acquiesce in 
allowing the bankruptcy process to unfold without the regulator 
intervening at the foreign subsidiary level.
---------------------------------------------------------------------------
     \27\ Bankruptcy Code 102(1) provides that ``after notice and a 
hearing'' includes (B) ``authoriz[ing] an act without an actual hearing 
if such notice is given properly and if . . . (ii) there is 
insufficient time for a hearing to be commenced before such act must be 
done, and the court authorizes such act . . . .''
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The Problems These Inadequacies Create for the Dodd-Frank Act
    As noted above, resolution plans under Title I of the Dodd-Frank 
Act focus on bankruptcy, and Title II of the Dodd-Frank Act is, 
explicitly, designed to be a fall-back solution to be invoked when 
bankruptcy is determined to be inadequate to avoid serious financial 
consequences on the U.S. financial system. But if the ``best'' 
resolution process we currently envision--one that, as noted above, (a) 
both minimizes losses and places them on appropriate, pre-identified, 
parties, (b) minimizes systemic consequences, and (c) does not result 
in a Government bail-out--involves, indeed, a recapitalization such as 
proposed by the FDIC with its SPoE procedure under Title II, \28\ then 
there is a disconnect between design and implementation. As a result, 
the resolution plans will fail to do what they are supposed to do--
prepare a SIFI for the most successful possible resolution--leading to 
OLA under Title II assuming primacy in terms of the resolution process. 
Moreover, the resolution plans, relentlessly focused on a bankruptcy 
process under Title I's own standards, will be addressing a different 
set of issues and will provide little guidance to the FDIC in its OLA 
proceeding. To have the statutory pieces ``fit'' together--to have 
resolution plans effectively prepare a firm for resolution, to have 
bankruptcy serve as its intended role as the primary resolution device, 
and (beneficially) to have the resolution plans be relevant to a 
proceeding under Title II of the Dodd-Frank Act ``just in case''--it 
makes sense to move, through limited but important changes to the 
Bankruptcy Code, from the ``bones'' of a successful two-step 
recapitalization process in the current Bankruptcy Code to a process 
that can deliver what it can only incompletely promise today.
---------------------------------------------------------------------------
     \28\ See sources cited, supra note 15.
---------------------------------------------------------------------------
Proposed Amendments to the Bankruptcy Code
    Bankruptcy can be an effective resolution mechanism, tracking major 
features of the FDIC's SPoE proposal (but run through a bankruptcy 
process, with bankruptcy rules and market-based controls) that will 
usually, if not virtually always, obviate the need to invoke OLA under 
Title II of Dodd-Frank. \29\ But to do so, it needs some focused 
amendments.
---------------------------------------------------------------------------
     \29\ Again, the Dodd-Frank Act is explicit that Title II cannot be 
invoked without a determination that bankruptcy resolution would be 
inadequate. See notes 5 and 6, supra.
---------------------------------------------------------------------------
    What are these changes? While any resulting bill will necessarily 
be complicated, \30\ at the center of effectuating a bankruptcy-based 
two-entity recapitalization of a SIFI holding company, are two 
principles. First, that there is sufficient long-term unsecured debt 
(or ``capital structure debt'') at the holding company level to be 
``left behind'' in the transfer to a bridge company so as to effectuate 
the recapitalization. (This is--or should be--largely an issue outside 
of bankruptcy law itself--and, indeed, as noted earlier, is central to 
a basically rule-based application of the FDIC's SPoE proposal under 
Title II of the Dodd-Frank Act. The precise level of those mandated 
capital requirements are being worked on, and already are significantly 
above those of 2008.) Second, that the bridge company otherwise be able 
to acquire all the assets, rights, and liabilities of the former 
holding company, including ownership of the former holding company's 
operating subsidiaries. \31\
---------------------------------------------------------------------------
     \30\ In addition to the proposal contained in the Appendix, both 
the Senate and the House had introduced in the last session focused 
bankruptcy bills that largely incorporated the features I discuss next. 
See S. 1861, 113th Congress, 1st Sess. (``The Taxpayer Protection and 
Responsible Resolution Act'') (December 2013); H. 5421, 113th Congress, 
1st Session (``The Financial Institution Bankruptcy Act'') (approved by 
the House via a voice vote on December 1, 2014).
     \31\ There is a third, important, question of access to liquidity 
by the bridge company that, formally is not a part of the bankruptcy 
process. While a potentially contentious issue, I believe there is a 
great deal of wisdom in David Skeel's analysis of this in Financing 
Systemically Important Financial Institutions, Chapter 3 of Kenneth E. 
Scott, Thomas H. Jackson, and John B. Taylor, supra note 4. In summary: 
I argue in this chapter that the widespread pessimism about a SIFI's 
ability to borrow sufficient funds--sufficiently quickly--to finance 
resolution in Chapter 11 is substantially overstated. The criticism 
appears to be based on the assumption that the largest banks have 
essentially the same structure as they had prior to the 2008 panic, 
thus ignoring the effects of the regulatory changes that have taken 
place as a result of the Dodd-Frank Act. Critics also do not seem to 
have fully considered the likelihood that the quick sale resolution of 
a SIFI--like prepackaged bankruptcies of other firms should require 
less new liquidity than the traditional bankruptcy process. (pp. 63-64) 
Recognizing, however, that there is still some residual concern, 
Professor Skeel ``conclude[s] that lawmakers should give SIFI's 
limited, explicit access to Fed funding, preferably by expanding the 
Fed's emergency lending authority under section 13(3) of the Federal 
Reserve Act,'' p. 65--where ``the Fed [is] constrained under 13(3) by 
the requirement that it lend on a fully secured basis'' as well as by 
the requirement that ``the Fed must also determine that the loan is 
needed to prevent systemic or other harm.'' (p. 85). In general, I 
think the Bankruptcy Code amendments outlined here should be made 
irrespective of the availability of Government-based liquidity. That 
discussion can be held separately, and should include whether an 
inability of the bridge company to access Government-based liquidity 
under some circumstances will make more likely use of OLA under Title 
II of the Dodd-Frank Act, where access to the orderly liquidation fund 
(OLF) is clear.
---------------------------------------------------------------------------
    Thus, the ``guts'' of the proposed amendments I believe are 
necessary to place bankruptcy law where the Dodd-Frank Act--in both 
Title I and Title II--envisions it should be, center on a provision 
that substantially sharpens the nature and focus of a sale of assets 
under Section 363 of the Bankruptcy Code. This provision contemplates a 
rapid transfer to and, in effect, recapitalization of, a bridge company 
(e.g., within the first 48 hours of a bankruptcy case) by a SIFI 
holding company (the debtor), after which the bridge company can 
recapitalize, where necessary, its operating subsidiaries. If the court 
approves the transfer, then the SIFI holding company's operations (and 
ownership of subsidiaries) shift to a new bridge company that is not in 
bankruptcy--and will be perceived as solvent by market-participants, 
including liquidity providers because it will be (effectively) 
recapitalized, as compared to the original SIFI, by leaving behind in 
the bankruptcy proceeding previously identified long-term unsecured 
(capital structure) debt of the original SIFI. After the transfer, the 
debtor (i.e., the SIFI holding company) remains in bankruptcy but is 
effectively a shell, whose assets usually will consist only of its 
beneficial interest in a trust that would hold the equity interests in 
the bridge company until they are sold or distributed pursuant to a 
Chapter 11 plan, and whose claimants consist of the holders of the 
long-term debt that is not transferred to the bridge company and the 
old equity interests of the SIFI holding company. This debtor in 
Chapter 11 has no real business to conduct, and essentially waits for 
an event (such as the sale or public distribution of equity securities 
of the bridge company by the trust) that will value or generate 
proceeds from its assets (all equity interests in the new, 
recapitalized entity) and permit a distribution of those equity 
interests or proceeds, pursuant to bankruptcy's normal distribution 
rules, to the holders of the long-term debt and original equity 
interests of the debtor (the original SIFI holding company).
    The details of accomplishing this are somewhat intricate and, of 
course, can vary, but it is useful, I believe, to trace the general 
ideas of how I envision this two-step recapitalization might be 
implemented in bankruptcy. The transfer motion would be heard by the 
court no sooner than 24-hours after the filing (so as to permit 24-hour 
notification--I would propose--to the 20 largest holders of unsecured 
claims, the Federal Reserve Board, the FDIC, and the Secretary of the 
Treasury, and the primary financial regulatory authority--whether U.S. 
or foreign--with respect to any subsidiary whose ownership is proposed 
to be transferred to the bridge company). And, because the provisions 
must stay qualified financial contract termination (and related) rights 
(including those based on cross-defaults in nonbankruptcy subsidiaries) 
for a period to allow the transfer to the bridge company to be 
effective in a seamless fashion, the transfer decision essentially must 
be made within a designated period (e.g., 48 hours) after the filing. 
There should be conditions on the ability of the court to authorize the 
transfer to the bridge company--but conditions that can be satisfied by 
advanced planning (e.g., resolution plans) or otherwise determined 
within a very short timeframe.
    Many of the remaining provisions that I believe would need to be 
adopted as well would be designed to permit the successful transfer of 
assets, contracts, liabilities, rights, licenses, and permits--of both 
the holding company and of the subsidiaries--to the bridge company.
    First, there are provisions applicable to debts, executory 
contracts, and unexpired leases, including qualified financial 
contracts. Conceptually, the goal of these provisions would be to keep 
operating assets and liabilities ``in place'' so that they can be 
transferred to the bridge company (within a 48-hour window) and, 
thereafter, remain ``in place'' so that ``business as usual'' can be 
picked up the bridge company and its operating subsidiaries once it 
assumes the assets and liabilities. This requires overriding ``ipso 
facto'' clauses (of the type that would otherwise permit termination or 
modification based on the commencement of a bankruptcy case or similar 
circumstance, including credit-rating agency ratings, whether in the 
holding company or in its operating subsidiaries), \32\ and it requires 
overriding similar provisions allowing for termination or modification 
based on a change of control, again whether in the holding company or 
in its operating subsidiaries, since the ownership of the bridge 
company will be different than the ownership of the debtor prior to the 
bankruptcy filing. These provisions need to be broader than Section 365 
of the Bankruptcy Code, for at least two reasons. First, perhaps 
because of the limited scope of the original ``purpose'' of Section 
363, bankruptcy doesn't have a provision expressly allowing for the 
``transfer'' of debt (although many debts are in fact transferred as a 
matter of existing practice under Chapter 11 ``going concern sales''). 
Unlike executory contracts, which might be viewed as net assets (and 
thus something to ``assume'') or as net liabilities (and thus something 
to ``reject''), debt is generally considered breached and accelerated 
(think ``rejected'') upon the filing of a petition in bankruptcy. \33\ 
But, if there is going to be a two-step recapitalization, the bridge 
company needs to take the liabilities it would assume ``as if nothing 
happened.'' Thus, provisions designed to accomplish that need to be 
included. Second, Section 365 doesn't deal with change-of-control 
provisions; amendments need to add that and extend it to debt 
agreements as well.
---------------------------------------------------------------------------
     \32\ While these provisions would affect the contracts, permits, 
liabilities, and the like of entities (e.g., affiliates such as 
operating subsidiaries) not themselves in bankruptcy, I believe they 
are fully authorized (at least for domestic subsidiaries), if not by 
Congress' Article I bankruptcy power, then by application of the 
independent (albeit related) Congressional power pursuant to the 
``necessary and proper'' clause of Article I, as interpreted since 
McCulloch v. Maryland, 4 Wheat. 316 (1819), see also United States v. 
Comstock, 560 U.S. (2010), since the bankruptcy of the SIFI cannot 
successfully be concluded without these provisions that permit the 
unimpeded transfer of the operating subsidiary's ownership to the 
bridge company. (The question of foreign subsidiaries, while complex, 
is being actively discussion by U.S. and foreign regulators, and 
legislation is being discussed in Europe and elsewhere that is designed 
to help assure these results extend to non-U.S. operations in the case 
involving the resolution of a U.S.-based SIFI holding company.)
     \33\ See David Skeel and Thomas Jackson, supra note 24.
---------------------------------------------------------------------------
    With respect to qualified financial contracts, there should be 
provisions in addition to those just mentioned. The stay on 
termination, offset, and net out rights should apply for the period 
from the filing until the transfer occurs, it is clear it won't occur, 
or 48 hours have passed. Because of this interregnum, when there is a 
likelihood that the transfer will be approved, and all of these 
qualified financial contracts (and related guarantees, if any) go over 
``in their original form'' to the bridge company, there is a 
requirement that the debtor and its subsidiaries shall continue to 
perform payment and delivery obligations. Conversely, because the 
counterparty may not know for sure what the outcome will be during this 
interregnum, there is a provision that the counterparty may promptly 
``cure'' any unperformed payment or delivery obligations after the 
transfer.
    Just as the principle of having the bridge company have the same 
rights, assets, and liabilities drive the provisions regarding debts, 
executory contracts, and unexpired leases just discussed (including 
qualified financial contracts), a similar provision is necessary to 
keep licenses, permits, and registrations in place, and does not allow 
a Government to terminate or modify them based on an ``ipso facto'' 
clause or a transfer to a bridge company.
    There are many other considerations. For example, in addition to 
voluntary bankruptcy proceedings initiated by the SIFI holding company, 
should Government regulators (such as the FDIC or FRB) have the power, 
under specified conditions, to initiate a bankruptcy case, and should 
it doing so be contestable? I believe Government regulators should be 
able to commence such proceedings, and (because of the very narrow time 
window between the filing and the transfer to a bridge company) such 
commencements should not be contestable in advance. \34\ But I can 
imagine a system in which the Government regulators could not place a 
SIFI holding company in bankruptcy, as they retain enormous powers, 
either to ``induce'' a so-called voluntary filing (as was the case in 
Lehman Brothers(, or to go directly to the initiation of an OLA 
proceeding under Title II of Dodd-Frank. While the issue needs to be 
decided, in my view, which way it is resolved is not integral to the 
integrity of the Bankruptcy Code or the proposed amendments I have 
discussed. Similarly, whether the proceedings should be in front of 
district judges, or bankruptcy judges, and whether the judges are from 
a pre-designated panel, are details that may be important in ensuring 
the effectiveness of a 24 hour transfer, but are not at the heart of 
the needed amendments.
---------------------------------------------------------------------------
     \34\ Although ex post damage remedies should then be available for 
what was judicially determined to be an improper filing. See Kenneth 
Scott, supra note 24, at 9-10.
---------------------------------------------------------------------------
Conclusion
    While the details are many, the concept is simple. Through modest 
amendments to the Bankruptcy Code, expressly enabling it to effectuate 
a rapid two-step recapitalization from a SIFI holding company to a 
bridge company (by leaving long-term unsecured debt behind), it indeed 
can be considered the primary resolution vehicle for SIFIs, as 
envisioned by the Dodd-Frank Act, limiting the role of Title II--and 
therefore administrative-based resolution--to the cases, that almost 
inevitably may occur, where we cannot contemplate today the causes or 
contours of the next crisis, so that the FDIC's inevitable discretion, 
compared to a judicial proceeding, becomes a virtue rather than a 
concern.
    Absent that (hopefully rare) need, however, I view the virtues of 
bankruptcy resolution over agency resolution to be several. First, the 
new company formed in the Section 363-like recapitalization sale (or 
transfer) is neither (a) subject to the jurisdiction of a bankruptcy 
court nor (b) subject to ``control'' by a Government agency, such as 
the FDIC, whereas the bridge company created in the SPoE process is 
effectively run, for a while at least, by the FDIC. \35\ In this 
bankruptcy process, the bridge company, appropriately, faces market-
discipline first and foremost; in Title II, there inevitably is a 
heavier layer of regulatory overlay and control. Second, and related, a 
bankruptcy process envisions at least the possibility that the market 
can determine the equity value of the new company (and thus the amount 
to be distributed to the creditors and old equity interests ``left 
behind''), whereas the FDIC's SPoE proposal relies on expert valuations 
for those distributions. \36\ Third, because of language in the Dodd-
Frank Act, \37\ the FDIC may push on its own initiative for the 
replacement of management (i.e., not permit management of the former 
SIFI holding company take similar positions in the bridge company). 
\38\ In the bankruptcy process, the Board of Directors, and management, 
of the newly created bridge-company, ideally, would be identified with 
the input both of the SIFI's primary regulators as well as the 
beneficiaries of the transfer and, importantly, would be subject to the 
approval of the district court in an open and transparent process at 
the time of the transfer of the holding company's assets and 
liabilities to the bridge company. Fourth, at various points, the FDIC 
has discretion that can amount to ex post priority determinations (such 
as whether liabilities other than predefined long-term unsecured debt 
gets transferred to the bridge company)--discretion that may be useful 
in extraordinary cases, but that is potentially a cause for undermining 
market confidence in the rule of law in other circumstances. \39\ 
Fifth, Title II treats the bridge company created in an OLA under Title 
II as a Government entity, exempt from taxes; \40\ I think that 
provision is a mistake, preferring the bridge company to its 
nonprotected competitors, and should not be replicated in any 
bankruptcy amendments, whose goal is to have the bridge company treated 
``just as'' the holding company was before the two-entity 
recapitalization. Sixth, and (perhaps) finally, I am concerned--as I 
suspect the FDIC is as well--that the actual use of SPoE under Title II 
of the Dodd-Frank Act will be subject to ex post criticism and 
investigation. Bankruptcy, with appropriate amendments--and its 
underlying judicial process subject to the rule of law, is in a more 
robust position to ``do the right thing'' in terms of fairly addressing 
the consequences of financial failure without having it necessarily 
lead to economic failure.
---------------------------------------------------------------------------
     \35\ See, e.g., FDIC SPoE, supra note 6, p. 76617 (``The FDIC 
would retain control over certain high-level key matters of the bridge 
financial company's governance, including approval rights for . . . 
capital transactions in excess of established thresholds; asset 
transfers or sales in excess of established thresholds; merger, 
consolidation or reorganization of the bridge financial company; any 
changes in directors of the bridge financial company (with the FDIC 
retaining the right to remove, at its discretion, any or all 
directors); any distribution of dividends; any equity based 
compensation plans . . . . Additional controls may be imposed by the 
FDIC as appropriate.'').
     \36\ FDIC SPoE, supra note 6, p. 76618 (``the SPoE strategy 
provides for the payment of creditors' claims in the receivership 
through the issuance of securities in a securities-for-claims exchange. 
This exchange involves the issuance and distribution of new debt, 
equity and, possibly, contingent securities . . . to the receiver. The 
receiver would then exchange the new debt and equity for the creditors' 
claims . . . . Prior to the exchange of securities for claims, the FDIC 
would approve the value of the bridge financial company. The valuation 
would be performed by independent experts . . . selected by the board 
of directors of the bridge financial company. Selection of the bridge 
financial company's independent experts would require the approval of 
the FDIC, and the FDIC would engage its own experts to review the work 
of these firms and to provide a fairness opinion.'').
     \37\ Dodd-Frank Act 206(4) (the FDIC shall ``ensure that 
management responsible for the failed condition of the covered 
financial company is removed''); see also Dodd-Frank Act 206(5) 
(similar provision for members of a board of directors).
     \38\ See FDIC SPoE, supra note 6, p. 76617 (``As required by the 
statute, the FDIC would identify and remove management of the covered 
financial company who were responsible for its failed condition'').
     \39\ See, e.g., FDIC SPoE, supra note 6, p. 76618 (in addition to 
identified categories, the FDIC retains ``a limited ability to treat 
similarly situated creditors differently'').
     \40\ Dodd-Frank Act 210(h)(10) (``Notwithstanding any other 
provision of Federal or State law, a bridge financial company, its 
franchise, property, and income shall be exempt from all taxation now 
or hereafter imposed by the United States, by any territory, 
dependency, or possession thereof, or by any State, county, 
municipality, or local taxing authority'').
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    I want to thank the Subcommittee for allowing me this opportunity 
to present my views. It is an honor to appear before you today. I would 
of course be delighted to answer any questions you may have about my 
testimony.


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                  PREPARED STATEMENT OF SIMON JOHNSON
  Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan School of 
                               Management
                             July 29, 2015
Main Points
  1.  Some financial sector firms have become so large and so complex 
        that handling any potential insolvency through standard 
        bankruptcy procedures is difficult and costly. The precise 
        distribution of losses across creditors and counterparties is 
        hard to predict, often with unforeseen consequences around the 
        globe. Such bankruptcy events can therefore have major 
        destabilizing effects on financial markets and the real economy 
        in the U.S. and internationally. \1\
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     \1\ Also a member of the Federal Deposit Insurance Corporation's 
Systemic Resolution Advisory Committee, the Office of Financial 
Research's Research Advisory Committee, and the Systemic Risk Council 
(created and chaired by Sheila Bair). All the views expressed here are 
mine alone. Underlined text indicates links to supplementary material; 
to see this, please access an electronic version of this document, 
e.g., at http://BaselineScenario.com. For important disclosures, see 
http://baselinescenario.com/about/.
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  2.  The systemic risks posed by the failure of large complex 
        financial institutions have been understood for several 
        decades--and use of the term ``too big to fail'' in this 
        context dates back at least to the 1980s. \2\ But in mid-
        September 2008 the U.S. authorities took the view that the 
        failure of Lehman Brothers could be handled through the 
        bankruptcy courts and might even have a cathartic effect on the 
        financial system. Within 24 hours of Lehman's bankruptcy, the 
        leadership at the Treasury Department and the Federal Reserve 
        Board of Governors realized that this was most definitely not 
        the case--the negative spillover effects of Lehman's bankruptcy 
        on the U.S. and global economies were huge. \3\
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     \2\ See Gary Stern and Ron Feldman, ``Too Big To Fail: The Hazards 
of Bank Bailouts'', Brookings Institution Press, 2004.
     \3\ See Andrew Ross Sorkin, ``Too Big To Fail: The Inside Story of 
How Wall Street and Washington Fought To Save the Financial System--And 
Themselves'', Viking, 2009. The assets and liabilities of Lehman 
Brothers were just over $600 billion, about 4 percent of U.S. GDP.
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  3.  Lehman's bankruptcy led directly to the U.S. Government's bailout 
        of AIG, a large insurance company, and to the unprecedented 
        support provided to money market mutual funds. When this failed 
        to stabilize the system, Goldman Sachs and Morgan Stanley were 
        allowed to become bank holding companies, which increased their 
        access to Federal Reserve support. The Troubled Asset Relief 
        Program (TARP) was rushed through Congress and quickly became 
        the largest injection of capital into private financial firms 
        in the history of the United States. Additional unprecedented 
        bailouts were provided to Citigroup in November 2008 and to 
        Bank of America in January 2009. Further statements of 
        guarantee were provided by top officials in February 2009, and 
        a stress test process--assuring market participants that the 
        Government believed leading banks had enough loss-absorbing 
        equity--was conducted in spring 2009.
  4.  These and related enormous forms of selective Government support 
        were not sufficient to prevent the most serious recession since 
        the 1930s from which, after 7 years, the U.S. economy is still 
        struggling to recover. \4\
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     \4\ For a recent comprehensive and accurate assessment, see ``The 
Cost of the Crisis: $20 Trillion and Counting'', a report by Better 
Markets, July 2015. Massive Government assistance was provided to big 
banks and some other parts of the financial sector but not generally to 
the nonfinancial sector--and hardly at all to families who owed more on 
their mortgages than their homes were worth.
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  5.  There has long been a ``resolution'' process, run by the Federal 
        Deposit Insurance Corporation (FDIC), that handles the 
        insolvency of banks that have insured retail (i.e., small-
        scale) deposits. For over 70 years, the FDIC has protected 
        insured depositors and not incurred any liability for 
        taxpayers. Shareholders are often wiped out and bondholders 
        face losses in FDIC resolution, in accordance with well-defined 
        and transparent criteria. However, prior to 2010, this FDIC 
        procedure could only be applied to banks with insured deposits.
  6.  In July 2010, Congress passed the Dodd-Frank Wall Street Reform 
        and Consumer Protection Act. Title II of this Act created an 
        Orderly Liquidation Authority that essentially broadened the 
        mandate and powers of the FDIC to include the resolution of 
        nonbank financial companies. \5\
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     \5\ See Section 204, creating the Orderly Liquidation Authority, 
and all related parts of Title II.
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  7.  However, this power is intended only as a back-up, in case 
        bankruptcy is determined--by the Secretary of the Treasury, 
        with the Federal Reserve and the FDIC--to be infeasible or 
        likely to cause unacceptable levels of collateral damage. 
        Titles I and II of Dodd-Frank make it clear that all firms 
        should be able to go bankrupt--and the point of the ``living 
        wills'' process is to force firms to change in order to become 
        resolvable through bankruptcy. (More on the difficulties of 
        bankruptcy is in Section B below.)
  8.  Since 2010, the FDIC has developed a resolution strategy for 
        large complex financial institutions in which there is likely 
        to be single point of entry in the resolution of any group of 
        firms under a bank holding company. \6\ In this strategy, 
        shareholders in the holding company would be wiped out (if the 
        losses are large enough) and debt would be converted to 
        equity--in order to recapitalize a new enterprise as a going 
        concern, presumably without the activities that incurred the 
        devastating losses. There would be a one day stay on creditors 
        of all kinds. \7\ There are also moves to end the automatic 
        termination of derivative contracts in the event of resolution. 
        \8\ This is intended to give the FDIC time to complete the 
        resolution process--and to allow operating subsidiaries to 
        continue in business.
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     \6\ See ``A Progress Report on the Resolution of Systemically 
Important Financial Institutions'', speech by Martin J. Gruenberg, 
chairman of the FDIC; May 12, 2015. Mr. Gruenberg makes it clear that 
the single point of entry is only one option for the FDIC's approach to 
resolution.
     \7\ See ``A Dialogue on the Costs and Benefits of Automatic Stays 
for Derivatives and Repurchase Agreements'', by Darrell Duffie and 
David A. Skeel, University of Pennsylvania Law School, January 2012.
     \8\ This stay is supported by the International Swaps and 
Derivatives Association (ISDA) Resolution Stay Protocol, but the 
coverage of this is still incomplete--it currently only includes major 
banks, not ``buy side'' investors.
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  9.  Repealing Title II of Dodd-Frank would be a mistake. Title II is 
        a backstop, in case bankruptcy proves infeasible (see Section C 
        below). Title II creates a clear mandate for advance planning 
        for private sector firms and for officials, and makes it 
        possible to create a structure for cross-border cooperation on 
        resolution. \9\
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     \9\ The FDIC and the Bank of England have a memorandum of 
understanding on resolution-related issues; this would likely not apply 
if a large complex financial institution were to file for bankruptcy.
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  10.  At the same time, we should recognize that:

    a.  Title I of Dodd-Frank requires credible living wills, in which 
        firms would be able to fail through bankruptcy. We are a long 
        way from having satisfactory living wills. Officials need to 
        press harder on this front; more on this in Section C below.

    b.  The largest and most complex financial firms need to become 
        much simpler and, most likely, smaller in order for either 
        bankruptcy to work (as required under Title I) or for the 
        FDIC's single point of entry strategy to work (if Title II 
        powers are used).

    c.  The FDIC's primary resolution strategy relies on there being 
        enough ``loss-absorbing capital'' at the holding company level. 
        But only equity is really loss-absorbing. ``Loss-absorbing 
        debt'' is an oxymoron--when creditors suffer major losses on a 
        mark-to-market basis, there is real potential for a systemic 
        panic, particularly as other related assets will be immediately 
        reduced in value.

    d.  We should be very concerned about the current international 
        push towards a Total Loss Absorbing Capacity (TLAC) approach 
        for bank holding companies. \10\ We currently have only 4-5 
        percent equity (and 95-96 percent debt) in our largest bank 
        holding companies. \11\ Resolution as designed by the FDIC will 
        likely not work in this scenario--the losses imposed on 
        creditors will have serious systemic effects. Bankruptcy would 
        be even more of a disaster. The result could easily be some new 
        form of Government-sponsored bailout, through the Federal 
        Reserve or through new powers granted by Congress (as happened 
        in September 2008). It is imperative that officials move to 
        greatly increase loss-absorbing equity in the largest, most 
        complex financial firms (see Section D below). \12\
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     \10\ This push is being led by the Financial Stability Board but 
it almost certainly represents a European attitude towards how to 
handle financial distress. Given that the European authorities are much 
more comfortable with continuing some version of Too Big To Fail--and 
providing bailouts to creditors under a wide variety of circumstances--
it is most unwise to follow their lead on this matter.
     \11\ See the December 2014 edition of The Global Capital Index, 
produced by Thomas Hoenig, vice chairman of the FDIC. Mr. Hoenig 
converts U.S. GAAP accounts to their International Financial Reporting 
Standards (IFRS) equivalent, as this better reflects the risks inherent 
in derivative positions. The new reporting of risk exposures to the Fed 
(on FR Y-15) produces numbers that are similar to those of Mr. Hoenig. 
For example, in Mr. Hoenig's index, the largest bank in the world at 
the end of 2014 was JPMorgan Chase, with a balance sheet of $3.827 
trillion (under IFRS); on its FR Y-15, JPMorgan Chase states its total 
risk exposure as $3.743 trillion.
     \12\ The Federal Reserve is moving capital requirements in the 
right direction, including with a higher requirement for loss-absorbing 
equity in the largest firms. But, as Mr. Hoenig's Global Capital Index 
shows, these buffers against losses remain very small relative to true 
risk exposures. For the integrated and persuasive case for higher 
capital requirements, see Anat Admati and Martin Hellwig, ``The 
Bankers' New Clothes: What's Wrong With Banking and What To Do About 
It'', Princeton University Press, 2013.
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The Problem With Bankruptcy
    There are two variants of the ``bankruptcy-only'' proposal. In both 
approaches, Title II of Dodd-Frank would be repealed--so the FDIC could 
not be involved in the failure of any bank holding company (or any 
financial firm, other than a bank with retail deposits).
    In the first variant, the bankruptcy code would be modified, for 
example to grant the kind of automatic stay now available only under 
FDIC resolution, but there would be no debtor-in-possession financing 
provided by the Government.
    The problem with this scenario is that it would be very difficult 
for a bankruptcy judge to enable any part of the financial firm to 
continue in business. The bankruptcy would be akin to complete 
liquidation or winding down, as was the case with Lehman Brothers. The 
losses to creditors in this scenario are large while the precise 
incidence of losses would take many years to determine fully. Under 
such an approach, the failure of a large complex financial institution 
would most likely result in chaos, along the lines experienced in 
September 2008.
    In the second bankruptcy-only variant, proponents argue that 
debtor-in-possession financing should be provided by the Government--
precisely because the private sector is highly unlikely to provide the 
scale of funding needed. To make this more palatable, this kind of 
funding is sometimes referred as a ``liquidity'' loan.
    But providing large scale funding from the Government to a 
bankruptcy judge is both a bad idea economically and politically 
infeasible. Judges lack the experience necessary to administer such 
loans. In all likelihood, this would become a form of bailout that 
keeps existing management in place. To support a large complex 
financial institution, the scale of loans involved--from the Treasury 
or the Federal Reserve--would be in the tens of billions of dollars (in 
today's prices) and there would be a very real possibility of taxpayer 
losses. The extent of executive branch engagement and congressional 
oversight would be limited. Most likely there would be both scope for 
both genuine concern and a dangerous broader collapse of legitimacy.
    It makes sense to examine ways to improve the bankruptcy code to 
make it easier for financial firms fail through bankruptcy--and this is 
completely consistent with making Title I of Dodd-Frank more effective. 
But any threats to rely solely on bankruptcy for the largest, most 
complex, and massively global firms are simply not credible. This would 
be the same kind of tactics that the Treasury resorted to under Hank 
Paulson in 2008--until the policy was dramatically reversed after the 
bankruptcy of Lehman Brothers. It was that reversal under President 
George W. Bush and President Barack Obama that created the modern 
expansive version of Too Big To Fail that haunts us still.
    Bankruptcy cannot work for the largest and most complex banks at 
their current scale and level of complexity. This is not a viable 
option under current law for the largest bank holding companies with 
their current scale and structure, even if the law is tweaked to allow 
for a longer stay on creditors. And changing the law more dramatically 
to add a bailout component (or ``Government-backed liquidity loans'') 
to bankruptcy procedures--but only for very large complex financial 
institutions--would not lead to good outcomes.
Bankruptcy and Living Wills
    Under current law--and as a matter of common sense--the Federal 
Reserve now needs to take the lead in forcing large complex financial 
institutions to become smaller and simpler.
    The legal authority for such action is clear. Under section 165 of 
the 2010 Dodd-Frank financial reform legislation, large nonbank 
financial companies and big banks are required to create and update 
``the plan of such company for rapid and orderly resolution in the 
event of material financial distress or failure.'' The intent is that 
this plan--known as a ``living will''--should explain how the company 
could go through bankruptcy (i.e., reorganization of its debts under 
Chapter 11 or liquidation under Chapter 7 of the Bankruptcy Code), 
without causing the kind of collateral damage that occurred after the 
failure of Lehman Brothers.
    This bankruptcy should not involve any Government support. It is 
supposed to work for these large financial companies just like it works 
for any company, with a bankruptcy judge supervising the treatment of 
creditors. Existing equity holders are typically ``wiped out''--meaning 
the value of their claims is reduced to zero.
    The full details of these living wills are secret--known only to 
the companies and to the regulators. \13\ But based on the publicly 
available information these living wills are not currently credible 
because the big banks remain incredibly complex, with cross-border 
operations, and a web of interlocking activities. \14\ When one piece 
fails, this triggers cross-defaults, the seizure of assets around the 
world by various authorities, and enormous confusion regarding who will 
be paid what. All of these effects are exacerbated by the fact that 
these firms are also highly leveraged, with much of this debt 
structured in a complex fashion (including through derivatives).
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     \13\ Public portions of living wills are available on the FDIC Web 
site. Plans filed on July 1, 2015, show some progress towards more 
disclosure. But there is nothing in the latest published living wills 
that suggests bankruptcy is currently a plausible approach to the 
potential failure of the largest bank holding companies.
     \14\ For a glimpse into the complexity of corporate structures 
across borders within individual large complex global financial firms, 
see the corporate network visualizations available at https://
opencorporates.com (e.g., for Goldman Sachs). As one global regulator 
reportedly has said, large banks live globally but die locally--so any 
bankruptcy (or resolution) has to sort out a myriad of intertwined 
obligations across multiple jurisdictions.
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    What then are the implications? The Dodd-Frank Act has some 
specific language about what happens if ``the resolution plan of a 
nonbank financial company supervised by the Board of Governors or a 
bank holding company described in subsection (a) is not credible or 
would not facilitate an orderly resolution of the company''.
    Not unreasonably, under section 165 of Dodd-Frank, the Fed and the 
FDIC, ``may jointly impose more stringent capital, leverage, or 
liquidity requirements, or restrictions on the growth, activities, or 
operations of the company, or any subsidiary thereof, until such time 
as the company resubmits a plan that remedies the deficiencies.''
    The company may also be required, ``to divest certain assets or 
operations identified by the Board of Governors and the Corporation, to 
facilitate an orderly resolution.''
    Some supporters of the big banks argue in favor of skipping 
bankruptcy and go directly to Title II resolution. But this Title II 
(of Dodd-Frank) authority is intended as a back-up--only to be used if, 
contrary to expectations, bankruptcy does not work or chaos threatens.
    As it is currently obvious that bankruptcy cannot work, the 
legislative intent is clear. The Fed and the FDIC must require 
significant remedial action, meaning that something about the size, 
structure, and strategy of the megabanks must change and these changes 
must be sufficient to allow bankruptcy (without massive systemic 
damage) to become a real possibility.
Global Issues and the Need for Additional Capital Requirements
    Writing in the March 29, 2011, edition of the National Journal, 
Michael Hirsch quotes a ``senior Federal Reserve Board regulator'' as 
saying:

        ``Citibank is a $1.8 trillion company, in 171 countries with 
        550 clearance and settlement systems,'' and, ``We think we're 
        going to effectively resolve that using Dodd-Frank? Good 
        luck!''

    This regulator has a point. \15\ The FDIC can close small- and 
medium-sized banks in an orderly manner, protecting depositors while 
imposing losses on shareholders and even senior creditors. But it is a 
stretch to argue that such a resolution authority will definitely 
``work''--i.e., prevent spillover systemic damage and negative impact 
on the real economy--for any failing large bank with significant cross-
border operations.
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     \15\ Although it must be pointed out that Citigroup's total risk 
exposure at the end of 2014 was $2.766 trillion, substantially larger 
than the number mentioned by the official, who must have been thinking 
only about on-balance sheet assets. One lesson from the experience of 
2007-08 and from the data now reported in FR Y-15 (Banking Organization 
Systemic Risk Reports, required by Dodd-Frank) is that we should think 
more in terms of total risk exposure.
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    The resolution authority granted under Dodd-Frank is purely 
domestic, i.e., it applies only within the United States. \16\ The U.S. 
Congress cannot make laws that apply in other countries--a cross-border 
resolution authority would require either a treaty-level agreement 
between the various Governments involved or some sort of 
synchronization for the relevant parts of commercial bankruptcy codes 
and procedures.
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     \16\ For a discussion of what would happen if global banks fail 
post-Dodd-Frank, see Marc Jarsulic and Simon Johnson, ``How a Big Bank 
Failure Could Unfold'', NYT.com, Economix blog, May 23, 2013.
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    There are no indications that such treaties will be negotiated--or 
that there are serious inter-governmental efforts underway to create 
any kind of cross-border resolution authority, for example, within the 
G20. \17\
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     \17\ The Memorandum of Understanding between the FDIC and the Bank 
of England is helpful in this regard but unlikely to prove sufficient 
to eliminate significant cross-border difficulties in the event of the 
failure of a large complex financial institution. This understanding 
also only applies in the case of FDIC resolution; it would not apply in 
the event of bankruptcy (i.e., without FDIC involvement).
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    The best approach for the United States today would be to make all 
financial institutions small enough and simple enough so they can 
fail--i.e., go bankrupt--without adversely affecting the rest of the 
financial sector. The failures of CIT Group in fall 2009 and MF Global 
towards the end of 2011 are, in this sense, encouraging examples. But 
the balance sheets of these institutions were much smaller--about $80 
billion and $40 billion, respectively--than those of the financial 
firms currently regarded as Too Big To Fail.
    To the extent that the authorities are unwilling or unable to make 
some banks smaller and simpler, they should substantially increase the 
required amount of loss-absorbing equity for those firms. \18\ Concerns 
about complexities associated with the failure of cross-border 
operations also strengthen the case for higher capital requirements (in 
the form of loss-absorbing equity, not an illusory TLAC requirement).
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     \18\ Senators Sherrod Brown and David Vitter have proposed a scale 
for capital requirements, with greater focus on the leverage ratio 
(i.e., less value attached to the importance of risk-weights), that 
would increase steeply for the largest and most complex financial 
institutions. This is a promising approach that deserves further 
legislative and regulatory attention. Given the issues with bankruptcy 
and resolution, discouraging scale and complexity makes sense. For 
further discussion, see Simon Johnson and James Kwak, 13 Bankers, 
Pantheon, 2010.
              Additional Material Supplied for the Record
 
 LETTER FROM THE NATIONAL BANKRUPTCY CONFERENCE SUBMITTED BY SENATOR 
                                MERKLEY



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