Have you ever wondered if the government has a plan to avoid another financial institution failure, or if there's a bigger (or smaller), better bailout plan in the works? As luck would have it, the Federal Deposit Insurance Corporation (FDIC) has a new and innovative plan to handle the next financial institution failure and possible bank bailout.

SEE: The History Of The FDIC

Learning from Previous Bailouts
The main problems with recent bailout attempts included: taxpayer-funded bailouts, bankruptcy and insolvency, mergers, acquisitions and takeovers. Previously, American taxpayers funded the AIG bailout and the United States government emerged as a majority shareholder in the new AIG. With the AIG plan, it remained difficult to return ownership to private hands through orderly market operations.

When Lehman Brothers entered bankruptcy, there was widespread disruption and destabilization throughout the U.S. and international financial markets. After Bank of America acquired Merrill Lynch, federal regulators then realized that even when existing financial institutions have sufficient capital and adequate management expertise to take over failing companies quickly, they tend to create even larger, more complex financial institutions, which may not be the most desirable situation.

SEE: The Collapse Of Lehman Brothers

What Might Work for Future Financial Institution Failures?
According to remarks by Martin Gruenberg, Acting Chairman of the FDIC, there is a creditor-supported, FDIC-guided plan to restructure, recapitalize and reprivatize the next systemically important financial institution to go by the wayside. Previously, the FDIC had limited powers and could only deal with insured deposit institutions.

The Dodd-Frank Act gives the FDIC the power to place non-bank parent holding companies into receivership. Once in receivership, the FDIC would create a new bridge company, and then would finally guide the newly capitalized company back into private ownership. The FDIC will appoint a board of directors and CEO to manage and operate the bridge company while restructuring takes place.

SEE: Dodd-Frank's Consequences

The Key Is in Shareholder and Creditor Treatment
The difference in the new plan is how shareholders and creditors are treated. The FDIC resolution plan eliminates current equity positions in the failed company. Under the FDIC plan, subordinated and senior unsecured debt of the failed company become equity positions and some of the remaining debtors receive convertible subordinated debt claims in the newly created company. In effect, the FDIC decides, in advance, who the new owners and creditors will be. The new owners, i.e., former creditors, will then elect a new board of directors, who will in turn appoint a new CEO.

The newly created company is fully capitalized through debt-to-equity conversions and has established credit-worthiness and relationships through unsecured debt-to-convertible subordinated debt conversions. Additionally, and perhaps most importantly, is that the newly created company will emerge directly from receivership as a private, non-government owned entity.

Other Features of the FDIC Plan

  • Limited taxpayer losses: The Dodd-Frank Act allows the government to provide limited debt guarantees to a newly created company, instead of the traditional, taxpayer-funded cash infusion from the Treasury.
  • Government repayment provision: The Dodd-Frank Act also established the Orderly Liquidation Fund (OLF). Under the OLF, the Treasury Department may provide temporary liquidity to a company during the restructuring period, but the funds must be repaid through asset recovery from failed firms, or from assessments levied on larger financial institutions.
  • The "living will" requirement: Financial institutions with assets of $50 billion and up must have a resolution plan in place. The plan tells the FDIC how the company should be managed in the event of a failure. Plans for companies with assets exceeding $250 billion are expected as early as July 2012.
  • No deposit insurance: This may be the only downside of the plan. If the failing company is not an FDIC-insured bank, the FDIC will only operate as the resolution authority and will not extend deposit insurance to the parent holding company or any subsidiaries.

How Effective Will the FDIC Resolution Plan Be?
The plan will take only the parent holding company into receivership, leaving any subsidiaries free to continue important operations in both the U.S. and international financial markets. Subsidiaries can operate with the confidence that the new parent holding company will already be privately owned and capitalized, and not subject to share price volatility as the government tries to sell its equity shares on the stock market.

The Bottom Line
The goals of the FDIC resolution plan are financial stability, accountability and viability for financial institutions that play a vital role in the overall health of the economy, and to the banking and financial systems. First, the plan facilitates financial stability by eliminating systemic risks that subsidiaries face when holding companies face liquidity problems. Second, the plan facilitates accountability because investors - both equity and debt holders - bear the losses of failed firms.

Accountability is further enhanced because taxpayers are essentially reimbursed through the asset recovery provision. Finally, the FDIC plan facilitates market viability because there is private market participation throughout the receivership process. If the FDIC resolution plan proves to be effective, then the government will avoid the next bailout through the use of a publicly guided, private-sector funded and managed workout agreement.

Related Articles
  1. Investing Basics

    4 Iconic Financial Companies That No Longer Exist

    Learn how poor management, frauds, scandals or mergers wiped out some of the most recognizable brands in the finance industry in the United States.
  2. Entrepreneurship

    10 Ways to Be a Successful Entrepreneur

    Are you hoping to launch your own business and work for yourself? If so, here are the top 10 tips for entrepreneurs.
  3. Investing

    The Enormous Long-Term Cost of Holding Cash

    We take a look into how investors are still being impacted by the memory of the tech bubble and the advent of the last financial crisis.
  4. Active Trading

    What Is A Pyramid Scheme?

    The FTC announced it had opened an official investigation of Herbalife, which has been accused of running a pyramid scheme. But what exactly does that mean?
  5. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  6. Insurance

    How the Federal Deposit Insurance Corporation (FDIC) Works

    Learn more about the Federal Deposit Insurance Corporation (FDIC) and what happens to your deposits over $250,000 if a member bank fails.
  7. Economics

    Federal Deposit Insurance Corporation (FDIC)

    The Federal Deposit Insurance Corporation (FDIC) insures deposits in banks and thrift institutions.
  8. Economics

    Why is Puerto Rico in So Much Debt?

    Learn about the origins and economic factors that led to the downfall of the Puerto Rican economy and what the U.S. government can do to fix the situation.
  9. Economics

    Some Industries Are More Bubbly Than Others

    Investors who want to avoid future bubbles should learn from the past in order to protect their investments.
  10. Mutual Funds & ETFs

    8 Ways to Protect Mutual Funds From a Financial Crisis

    Discover eight strategies you can use to protect your mutual fund investments from the next financial crisis, including which types of funds to buy and avoid.
  1. Are 401ks FDIC insured?

    The Federal Deposit Insurance Corporation (FDIC) works as a protector for customers when banks and financial institutions ... Read Full Answer >>
  2. Does the FDIC cover identity theft?

    When a third party gains access to your bank account and conducts transactions without your consent, the FDIC does not have ... Read Full Answer >>
  3. Does the FDIC cover credit unions?

    The Federal Deposit Insurance Corporation (FDIC) does not cover credit unions. The FDIC only insures deposits in banks and ... Read Full Answer >>
  4. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  5. Does the FDIC cover business accounts?

    Bank deposits owned by corporations, partnerships, limited liability companies (LLCs), and unincorporated associations, including ... Read Full Answer >>
  6. Are variable annuities FDIC insured?

    Variable annuities are not insured by the Federal Deposit Insurance Corporation (FDIC), which regulates only bank products. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center