I want to end by briefly addressing several criticisms that have been made of the Dodd-Frank Act's orderly liquidation authority and the Board's TLAC proposal. One criticism is that there is no need for the backup orderly liquidation authority because the Bankruptcy Code provides an adequate framework for the resolution of any financial company. As Title II of the Dodd-Frank Act recognizes, however, the Bankruptcy Code may not be adequate to minimize the systemic impact of the resolution of a systemically important financial firm. The Bankruptcy Code does not direct the judge to take financial stability into account in making decisions, and it does not provide other important stabilizing features of the orderly liquidation authority, such as government liquidity support and stay-and-transfer treatment for qualified financial contracts.

A related line of criticism holds that the orderly liquidation authority enshrines "too big to fail" and provides for taxpayer bailouts of systemically important firms through the orderly liquidation fund. However, under the Board's proposed TLAC rule, a failed GSIB would be recapitalized by its private-sector long-term creditors (whose debt claims would be converted into equity), not by the government. The orderly liquidation fund would be used only to provide liquidity support, not to inject capital...The rating agencies no longer assume that the U.S. government will take extraordinary actions to prevent the failure of systemically important U.S. financial firms.

Finally, one criticism that has been leveled at our TLAC proposal is that imposing long-term debt requirements on GSIBs will lead those firms to increase their leverage and thereby raise their probability of failure, and that they should instead be required to hold higher levels of equity capital... [T]o protect financial stability, we must reduce not only the probability that a GSIB will fail, but also the damage that its failure could do if it were to occur. At the point of failure, a banking firm's equity capital is likely to be zero or negative, so to improve GSIB resolvability, our proposal requires GSIBs to have a thick tranche of gone-concern loss-absorbing capacity to ensure that resolution authorities will have the necessary raw material to manufacture fresh equity and recapitalize and stabilize the firm...

I want to end by briefly addressing several criticisms that have been made of the Dodd-Frank Act's orderly liquidation authority and the Board's TLAC proposal. One criticism is that there is no need for the backup orderly liquidation authority because the Bankruptcy Code provides an adequate framework for the resolution of any financial company. As Title II of the Dodd-Frank Act recognizes, however, the Bankruptcy Code may not be adequate to minimize the systemic impact of the resolution of a systemically important financial firm. The Bankruptcy Code does not direct the judge to take financial stability into account in making decisions, and it does not provide other important stabilizing features of the orderly liquidation authority, such as government liquidity support and stay-and-transfer treatment for qualified financial contracts.

A related line of criticism holds that the orderly liquidation authority enshrines "too big to fail" and provides for taxpayer bailouts of systemically important firms through the orderly liquidation fund. However, under the Board's proposed TLAC rule, a failed GSIB would be recapitalized by its private-sector long-term creditors (whose debt claims would be converted into equity), not by the government. The orderly liquidation fund would be used only to provide liquidity support, not to inject capital...The rating agencies no longer assume that the U.S. government will take extraordinary actions to prevent the failure of systemically important U.S. financial firms.

Finally, one criticism that has been leveled at our TLAC proposal is that imposing long-term debt requirements on GSIBs will lead those firms to increase their leverage and thereby raise their probability of failure, and that they should instead be required to hold higher levels of equity capital... [T]o protect financial stability, we must reduce not only the probability that a GSIB will fail, but also the damage that its failure could do if it were to occur. At the point of failure, a banking firm's equity capital is likely to be zero or negative, so to improve GSIB resolvability, our proposal requires GSIBs to have a thick tranche of gone-concern loss-absorbing capacity to ensure that resolution authorities will have the necessary raw material to manufacture fresh equity and recapitalize and stabilize the firm...

What we have is a fundamental flaw in the relationship between government and the financial sector resulting from the inability or unwillingness to find a way to forgo intervention in crises. And the impact of this flaw is growing. At the end of 1999, the government safety net including both the implicit support I just outlined and explicit support provided by programs such as deposit insurance and pension guarantees covered 45 percent of financial sector liabilities, according to Richmond Fed researchers. By the end of 2011, that number had grown to 57 percent, about the same size it was at the end of 2009, despite the many new regulations we have put in place since the crisis.

Greater capital buffer requirements and measures to beef up ex-ante constraints on risk-taking are important, but theyre not infallible. New opportunities for risk-taking will always emerge as financial markets and economies evolve, and it is asking too much to expect front-line supervisors to forever substitute for well-aligned incentives. Moreover, stronger restraints on risk-taking increase the incentive for market participants to find a way to operate outside the regulated sector. This regulatory bypass gives rise to whats come to be called shadow banking

a topic we will be hearing more about this afternoon

The Dodd-Frank Act lays out a path toward making bankruptcy workable for large financial institutions. The Act requires these institutions to create resolution plans, also known as living wills. These are detailed plans that explain how a financial institution could be wound down under U.S. bankruptcy laws without threatening the rest of the financial system or requiring government assistance. The plans explain how to disentangle the many different legal entities sometimes numbering in the thousands that make up a large financial firm. Under the Dodd-Frank Act, large banks and other systemically important firms are required to submit these plans on an annual basis for review by the Fed and the FDIC.

Resolution planning provides a structured approach for understanding whats likely to happen in the event a large financial firm fails. In contrast, in past crises policymakers found themselves with little or no preparatory work to draw on. In fact, the process has already proven valuable by giving firms a better and more detailed understanding of their legal structure, and many have used the process to reorganize themselves and eliminate unneeded legal entities.

Resolution planning wisely does not take the current operating profile of large financial firms as given; the current characteristics of these firms evolved in response to the precedents set by regulators avoiding the use of bankruptcy.

A holistic approach is needed that both provides a credible resolution process for large, complex and interconnected banks, uses enhanced prudential standards and initiatives to further reduce the probability of default and the social losses associated with a default, and that incents management to intervene early to address incipient problems before they threaten the viability of the firm. Relying solely on resolution is not sufficient. Until the Title II resolution process is used, there will remain uncertainties regarding how well this approach will work in practice—especially in a time of market stress. For this reason it is also important to continue to pursue a number of alternative approaches.

The resolution mechanism created by Title II of Dodd-Frank is gaining greater operational credibility as the FDIC builds out its single-point-of-entry approach. With each rule, policy statement, cross-border agreement, and firm-specific resolution plan, that credibility is further increased. Additional measures such as those I have suggested today will continue to enhance this third option of orderly resolution, and relieve government officials of the Hobson's choice of bailout or disruptive bankruptcy for systemically important financial firms.

The most important systemic vulnerabilities that have not been subject to sufficient regulatory reforms are those created in short-term wholesale funding markets. In the recent financial crisis, severe repercussions were felt throughout the financial system as short-term wholesale lending against all but the very safest collateral froze up. Although short-term wholesale funding levels at major U.S. and foreign banking firms are lower than they were at the outset of the crisis, major global banks remain significant users. High levels of such funding increase the probability of severe funding problems at, and thus the failure of, major financial firms. They also complicate the orderly resolution of major financial firms in the event of failure.Indeed, precisely because an effective orderly resolution mechanism provides for continued funding of certain short-term creditors to staunch potentially calamitous runs, that type of funding will not be subject to the increased market discipline resulting from the creation of a credible resolution process. This fact only strengthens the case for measures to limit the potential of short-term wholesale funding to be an accelerant of systemic problems.

Resolution planning will require a great deal of hard work. But I see no other way to ensure that policymakers have confidence in unassisted bankruptcy and that investors are convinced that unassisted bankruptcy is the norm, both of which strike me as necessary to solving the "too big to fail" problem. Resolution planning provides a framework for identifying the actions we need to take now to ensure that the next financial crisis is handled appropriately, in a way that is fair to taxpayers and establishes the right incentives.

Another reform that will take time to complete is the establishment of a global framework for resolving large, systemically important banks...  As many of you know, in the United States, the Federal Deposit Insurance Corporation is developing a preferred approach to resolution for such rare cases: the single-point-of-entry (SPOE) approach. This approach may be gaining some traction internationally. In my view, SPOE can be a classic "simplifier," making theoretically possible something that seemed impossibly complex.

Under the SPOE approach, the home country resolution authority for a failing banking firm would effect a creditor-funded parent company recapitalization of the failed firm. To do so, the resolution authority would first use available parent company assets to recapitalize the firm's critical operating subsidiaries, and then would convert liabilities of the parent company into equity of a surviving entity. This approach would have the effect of concentrating the firm-wide losses on the parent company's private sector equity holders and creditors. The SPOE approach places a high priority on what your own President Weidmann recently described as "the principle of liability," meaning that those who benefit should also bear the costs.

...

I will briefly discuss the Fed's proposal for oversight of foreign banks operating in the United States, which carries out a mandate from the Congress under the Dodd-Frank Wall Street Reform and Consumer Protection Act.2 Our proposal represents a targeted set of adjustments aimed at reducing the risks posed by the U.S. operations of large foreign banks to U.S. financial stability that were revealed during, and in the aftermath of, the recent financial crisis. The proposal is not intended to create a disadvantage for foreign banks in the U.S. market. Rather, the proposal is part of a larger set of regulatory reforms that substantially raises standards for all banking organizations operating in the United States and aims to achieve the goals we share with Germany: vigorous and fair competition and a stable financial system. Indeed, in some sense it follows the lead of the European Union and its member states in ensuring that all large subsidiaries of globally active banks meet Basel capital rules. We believe that our foreign bank proposal, which would increase the strength and resiliency of the U.S. operations of these firms, would meaningfully reduce the likelihood of disruptive ring-fencing at the moment of crisis that could undermine an SPOE resolution of a large foreign bank. We are fully committed to the international efforts to address cross-border resolution issues and to maintaining strong cooperation between home and host supervisors during normal and crisis periods.

From the Q&A on resolution authority: 

SEN. BUNNING: .Now we've handed you a job in my mind that's damn near impossible. You're going to have to pick and choose who's too big to fail. You and a group of so many people. But you particularly.

And it's a subjective view. It's not, it doesn't say these are the categories, it says that you should decide who is too big to fail. Is that accurate? Do you accept that as an accurate review of what's in the --

MR. BERNANKE: No, Senator, what we have to determine is which firms are systemically critical but they will be subject to this resolution regime, which means that they will fail and the creditors will lose money.

SEN. BUNNING: But it's subjective, it's not objective.

MR. BERNANKE: I think it'll be important for us to develop as many clear criteria as we possibly can. It'll be partly subjective, yes.

[T]here should be a clear expectation that the shareholders and creditors of the failing firm will bear losses to the fullest extent consistent with preserving financial stability. To personalize things for this audience, we must ensure that if you have invested money in a large financial firm that runs aground, you will suffer losses. Shareholders of the firm ultimately are responsible for the organization's management (or mismanagement) and are supposed to be in a first-loss position upon failure of the firm. Shareholders, therefore, should pay the price for the firm's failure and should not benefit from a government-managed resolution process.

I would further suggest that the importance of proposed requirements that each large financial firm produce a so-called living will is that this device could better tie the supervisory and resolution processes together.

[R]egulatory improvements alone, as essential as they are, won't be enough. This cycle of crisis, rescue and by-pass is destined to recur, and with ever more force, unless we alter what market participants believe will happen when a financial firm becomes distressed. Recognizing that market discipline requires that creditors expect to bear losses on insolvent counterparties, many financial reform proposals create a new failure resolution process that gives policymakers additional "tools," besides the existing bankruptcy code, for handling failing firms.

So what can we do about the “too big to fail” problem? It is clear that we must develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only legislative action domestically but intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Many times in the last year I have expressed my astonishment that Congress was able to approve $700 billion in TARP funds in approximately one week and yet 18 months have passed since Bear Stearns was acquired by JPMorgan and there is still no resolution authority for the largest financial firms.

The Federal Reserve's participation in this decisionmaking process {resolution process for nonbank financial firms} would be an extension of our long-standing role in protecting financial stability, involvement in the current process for invoking the systemic risk exception under the FDI Act, and status as consolidated supervisor for large banking organizations. The Federal Reserve, however, is not well suited, nor do we seek, to serve as the resolution agency for systemically important institutions under the new framework.