One justification for the very broad powers of the regulators in the Dodd-Frank Act Title II’s Orderly Liquidation Authority mechanisms is that it would allow the FDIC to act very quickly. This usually means “act very quickly once the process is initiated,” but one key aspect of insolvency resolution is that it also has to be initiated quickly, so as to limit shareholder and manager moral hazard to make things even worse.

Yet, the initiation of insolvency procedures in Dodd-Frank follows from a so-called “three key turning” mechanism. The first key is that the Treasury secretary has to suggest that the firm is “in default or in danger of default,”‘ and have consulted with the President (possibly the fourth key). The second and third key are that two-thirds of the Federal Reserve board, and two-thirds of either the Security and Exchange Commission board for investment banks, two-thirds of the Federal Insurance Office board for insurance companies, or two-thirds of the Federal Deposit Insurance Corporation board must have recommended the initiation of resolution procedures. As should be apparent, this process requires the coordination of multiple agencies, and multiple board members, and is unlikely to be triggered rapidly, if only because of coordination considerations.

Moreover, because initiating insolvency resolution is an admission of failure of prior control, and because the costs of delaying the initiation are essentially shifted onto the FDIC that manages the resolution process, there’s incentives not to recognize the insolvency or to keep hush about it. This was a huge problem for example during the 1980’s Savings & Loans crisis, where insolvent thrifts remained opened for an average period of 17 months before resolutions were initiated, and in a few cases for as much as ten years. The 1993 FDIC Improvement Act sought to fix this problem, by giving the FDIC power to initiate procedures itself, rather than having to rely on the bank’s primary regulator, and by allowing the FDIC to act before the bank is effectively insolvent through what is called “prompt corrective action.” This has, however, obviously not been a success, as in most cases of bank failures during 2008-2009 there were no prompt corrective actions taken, and procedures were initiated after the bank’s equity had dropped in negative territory. This means that, even without rules that require the coordination of multiple agencies with possibly misalligned incentives, regulators’ incentives and knowledge problem generally pushes the initiation of insolvency procedures back.

We actually do have something close enough to a benchmark to see how hard it might be for all “3 keys” to agree and coordinate. The Systemic Risk Exemption of the 1993 FDIC Improvement Act has a similar mechanism, where it required a two-third vote of the FDIC’s board, a two-third vote of the Fed’s Board of Governors, and the Treasury Secretary who has to consult with the President. Triggering this exemption allows the FDIC to bypass the “least cost resolution” provisions of the FDICIA, and allows it to be more generous with its “insurance” fund, providing larger coverage to “uninsured” depositors than is usually the case. It’s essentially an institutionalized bailout procedure.

Despite the fact that it would have allowed the FDIC a lot more flexibility, the Systemic Risk Exemption was triggered only 3 times in nearly 20 years. All 3 cases are recent, as those are Citigroup, Bank of America and Wachovia. In the case of Wachovia, those powers were ultimately not used, as Wells Fargo purchased it instead. This is suggestive that those powers are hard to invoke and use, and might suggest something about triggering the Orderly Liquidation Authority. On the other hand, it is true that the Systemic Risk Exemption could have been triggered much more often under a director that is more bailout-happy than Sheila Bair was (say, Geithner for example).

Given those features of the Orderly Resolution Authority, there’s a chance that initiation might be delayed. Delayed initiation means larger losses, more adverse market reactions, and stronger temptations to bailout, with accompanying calls for further regulation.

Why am I telling you all this? Well, ZeroHedge posted a very revealing figure, detailing the new European Bank Resolution directives and what could be called its “8 key turning mechanism”…

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