The most obvious target was Bank of America Corp., which saw its stock price plummet amid concerns about its exposure to Europe and significant put-back risk. Despite the bank's claims that it had sufficient capital and liquidity to weather the storm, some analysts began publicly saying its days were numbered.
That, in turn, gave rise to speculation about whether regulators were prepared to take down a large bank, or if the new Dodd-Frank resolution authority was even workable.
With that in mind, we offer the following frequently asked questions to sort out whether a failure is in the offing and how regulators would know when to take out a big bank.
Is Bank of America about to fail?
No. The Charlotte-based banking company is in a weakened state, but it's far from dying. It has a significant amount of capital and — much more importantly — liquidity. In the cases of other large bank failures, including Washington Mutual, liquidity turned out to be the key factor. Facing a bank run, Wamu was rapidly losing its deposit base, forcing regulators to step in.
B of A for right now seems to be having no problem paying its bills, and there are no signs of a bank run. At the end of the second quarter, it held roughly $402 billion in excess liquidity, giving it some room to breathe.
Then why are people talking about it?
Psychology is at least as important as the numbers in stressful times. The name of the game has always been confidence. So long as investors and the public believe Bank of America is not going to fail, it probably won't. The minute the market concludes the bank is dead in the water, however, it will suddenly have a lot more trouble operating in a normal fashion.
Confidence, for better or for worse, is often a reflection of stock price. So when investors and the public see a bank's stock crater, as happened to B of A, they start to ask whether the market has confidence in it. That, in turn, leads to more questions about a firm's health, which can undermine its position further.
How will regulators know when to step in?
This is the $64 billion question, because it relies on a subjective judgment from regulators.
"There is no trigger for when regulators should step in," Carney said. "It's entirely discretionary."
This is true, to a point. The Dodd-Frank law, which created new resolution authority for large systemic companies, does not have a hard and fast mechanism that would require regulators to act. Indeed, the process is somewhat labyrinthine, as I will explain shortly.
But the law does offer some clues for when regulators should step in, saying the agencies should act if a systemically important firm is "in default or in danger of default." What this essentially means is this: the company would have to be close to or in the process of filing bankruptcy. Moreover, for regulators to step in, they would have to conclude that it would be less disruptive for the market to seize the institution than allowing it to enter bankruptcy.
Would we have clues beforehand?
Yes. There are several signs that an institution is nearing collapse. Can it pay its bills? Is it low on capital? Low liquidity or low capital are sure signals an institution is about to fail — just look at Lehman Brothers.
It's worth noting that everyone knew Lehman Brothers was in dire shape before it filed for bankruptcy in 2008 — they just assumed it would be bought or bailed out. The surprise and disruption that ensued wasn't due to the fact that Lehman was unexpectedly weak as it did from the fact that the government allowed it to go down.
In other words, if a large bank were about to fail, you would probably have some idea it was about to happen. And we just aren't there yet with Bank of America or any other large institution.
But are regulators ready to step in if they have to?
Yes. One of Carney's other concerns was that regulators simply won't have enough time to plan for the dismantling of an institution like Bank of America. Accordingly, somehow they will find a way to bail it out rather than put it in receivership. (They can't bail a bank out anymore, but let's leave that aside for a moment.)
But the truth of the matter is this: the Federal Deposit Insurance Corp., which was given resolution powers over systemically important companies under the Dodd-Frank Act, has been actively planning how to take down any of the largest banks for the past two years. This isn't a scoop and you shouldn't go sell all your large bank stock. The agency has been open about the fact that it needs to be ready to act in the next crisis. The FDIC has been conducting war games where it plays out the rapid collapse of a large institution, and how and when it should step in.
The FDIC also has examiners in all of the large banks, so if there are problems there we can't see, that doesn't mean the agency is equally blind. It doesn't need months to prepare — it's ready.
But don't regulators need those living wills from the big banks? Are they ready yet?
No and no. The FDIC and Federal Reserve Board are close to issuing a final rule detailing how institutions should provide plans for their own dismantling in the event of a crisis. There is little doubt those plans will be very helpful in the event of a crisis.
But it isn't like the agencies are sitting on their hands waiting for them to be delivered, either. They have the authority to take down a large bank holding company, and they are actively testing contingency plans. If they need to act before the living wills are complete, there's every expectation they can do so.
Who will determine when to fail a bank?
Here's where it gets a bit messy. Under Dodd-Frank, the FDIC board and the Fed board have to recommend to the Treasury Secretary (who consults with the president) to step in.
If the company does not consent to the receivership, they can appeal it to the U.S. District Court in D.C., which must issue an order within 24 hours to stop it, if warranted. If the court doesn't, the receivership automatically goes forward.
What worries me here is the political element to all of this. The federal banking regulators are used to making the call for whether to take down a bank — the Treasury secretary is not.
So do you think the Treasury secretary will chicken out?
I would be more worried if I saw that he or she had any alternative.
One of the underlying fears of the whole debate right now is that there is still some way to bail out a bank if it gets into trouble — or that there is a good reason to do so. I frankly don't see either one.
For one, Dodd-Frank makes it much, much harder, if not totally impossible, to bail out an individual institution. Is there some way around it? It's possible someone could think one up, but it's not readily apparent.
Secondly, however, is that Dodd-Frank gave regulators an underappreciated power that removes the need for a bailout: bridge bank authority.
If regulators want to, they can take over an institution and run it themselves as they unwind its operations. This is a critical power they simply didn't have before for bank holding companies or nonbanks. The FDIC used this successfully with the failure of Indymac Bank, running the bank for a few months before selling it.
Such a power allows regulators to step in and keep the institution going in the short run while it takes its time to plot its demise. It theoretically stems a market panic while also ensuring that an institution's management and stockholders aren't just bailed out in the name of preventing systemic risk.
"You don't have to bail people out when you have a bridge structure," said Karen Shaw Petrou, managing partner at Federal Financial Analytics. "You have an orderly liquidation, which isn't the same. There isn't a need for a bailout if you have that, executing discipline in a timely fashion."