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Treasury: Keep large-bank failure backstop, but prioritize new bankruptcy code

The U.S. Treasury Department outlined recommendations to establish a new "Chapter 14" bankruptcy code while maintaining a revised orderly liquidation authority, or OLA, for emergency situations.

The Treasury criticized the current bankruptcy framework for not considering companies engaged in significant derivatives transactions and short-term lending, which are large parts of the credit market but also a huge vulnerability for financial firms. In a report commissioned by President Donald Trump on Feb. 3, 2017, and released Feb. 21, 2018, the Treasury proposed installing a framework originally floated by the right-leaning Hoover Institution: a two-entity recapitalization model that would involve the transfer of assets and certain liabilities to a new bridge company. The bridge company would allow counterparties to transfer derivatives and other financial contracts as opposed to immediately liquidating or terminating their agreements.

The Chapter 14 proposal would bear the burden of bankruptcy on shareholders, management and specified creditors "just as they do under the ordinary bankruptcy process," the report stated. The recommendations would leave liable any shareholders of the debtor financial company in addition to holders of unsecured long-term debt at the holding company level. At the newly established bridge company, a special trustee would hold the entity's equity, and the new owners of the bridge would select its new management.

The report establishes the legislative foundation for changes to the OLA, which was established by the Dodd-Frank Act but has long been criticized by Republicans due to its reliance on a taxpayer-funded orderly liquidation fund, which is held at the Treasury but employed at the discretion of the Federal Deposit Insurance Corp. The Treasury recommends keeping the OLA as an "option of last resort," noting that while the Chapter 14 process should mitigate the bankruptcy of a large financial firm, insufficient private financing may require the OLA process.

House Financial Services Committee Chairman and longtime OLA-critic Jeb Hensarling, R-Texas, said in a statement that he is disappointed that the Treasury did not recommend repealing the backstop entirely.

"Although I have been pleased or even excited about Treasury’s previous reports, this one disappoints," Hensarling said.

The Treasury still suggested tweaking the OLA to establish a more predictable allocation of losses to shareholders and creditors, as opposed to the "unchecked administrative discretion" that the regulators currently have over use of the orderly liquidation fund. The report proposes removing the FDIC's ability to assess creditors on an ad hoc basis, requiring a bankruptcy court to adjudicate claims, and repealing the tax-exempt status for a bridge company. In order to "enhance predictability," the Treasury also wants the FDIC to explicitly commit itself to a single-point-of-entry resolution strategy, which it says would allow market participants to better price exposure risks.

On the orderly liquidation fund itself, the Treasury proposes more stringent rules on its use. The report suggests a shorter repayment period of any advances taken from the fund and prioritizing loan guarantees over direct lending to prioritize return to private credit markets. To incentivize use of private funding markets while also limiting exposure to taxpayers, the Treasury recommended incorporating a premium interest rate on any direct lending and requiring any loans to be issued on a secured basis, with high-quality assets as collateral.

The Treasury also wants the OLA to undergo stronger judicial review, proposing that a court have the power to fully review a Treasury secretary's order to place a failing financial company into receivership. Additionally, the report proposes either allowing a financial company to appeal the appointment of the FDIC as receiver.