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Shareholders to be Wiped Out First if Bank Fails

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First, the good news: Today the Federal Deposit Insurance Corporation and the Bank of England released a paper outlining a cooperative plan for resolving failing, globally active, systemically important financial institutions:  better known to bankers as G-Sifis, and better known to the general public as financial institutions that are "too big to fail."

And now the bad news: Shareholders will be first in line to absorb any losses incurred in winding up a failing bank. One Financial Times reporter put it less delicately: "Shareholders should expect to be wiped out." 

If an eye, or CEO, offend thee, pluck it out
If it makes you feel any better, unsecured creditors are next in line to feel the pain, with "their claims [being] written down to reflect any losses that shareholders cannot cover."  If that doesn't offer you any sort of palliative effect, consider this: Both of the aforementioned approaches would be accompanied by "the replacement of culpable senior management."

Now there's something that would have made all of us feel at least a little better in the aftermath of TARP, the $700 billion Troubled Asset Relief Program of 2008 that stabilized America's wobbling banks. Culpability of senior management is something the federal government should have considered demanding in return for nearly a trillion dollars in bailout money. Here are a few other details of the joint FDIC/BOE plan announced today:

  • Sound subsidiaries, both domestic and foreign, would be kept open and operating, thereby limiting contagion effects and cross-border complications.
  • In both countries, whether during execution of the wind-up or thereafter, restructuring measures might be taken, particularly in the parts of the business causing the distress.
  • The offending business units might be shrunk, broken into smaller entities, or even liquidated.

 Better tools, better fixes
"The failures of G-Sifis that confronted the U.S. and U.K. in 2008 were unprecedented in scale, complexity and interconnectedness. They also outstripped the capabilities of the legal frameworks in place." So writes Paul Tucker, deputy governor for financial stability at the BOE, and Martin Gruenberg, head of the FDIC, in an Op-ed for today's Financial Times, explaining the thinking and motivation behind the joint plan.

When the financial crisis struck in 2007, the FDIC only had the power to put banks and other failing financial institutions into receivership, not wind them down. The BOE had even more limited bank resolution powers at the time. Thankfully, that situation has changed on both sides of the Atlantic, with America's Dodd-Frank financial reform legislation of 2010 and the U.K.'s 2009 banking act giving both countries explicit capabilities to deal with failing banks.

 You pays your money and you takes your chances
When Lehman Brothers declared bankruptcy in September 2008, it not only caused a giant stir here, it also caused a giant stir in London, where the investment bank had a sizable operation. It's unarguable that, still today, if American giants like Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and JPMorgan Chase run into serious problems and need to be wound down, there are global considerations as well as domestic. Conversely, the failure of a big bank in the U.K., like an HSBC (NYSE: HSBC  ) or a Barclays (NYSE: BCS  ) , will affect what happens here in the U.S.

No shareholder wants to be at the top of the list when it comes to this sort of thing. Of course, neither do bondholders. Top executives probably aren't too pleased with the idea of being fired in the wake of insolvency either. But something had to be done. More than four years after the onset of the financial crisis, the problem of too big to fail remains, as does the issue of cross-border contagion. This doesn't solve either problem completely, but it's a start. Keeping banks healthy, or being able to properly deal with them when they're sick, is good for everybody in the end.

Thanks for reading, and for thinking. Speaking of G-Sifis (rolls right off the tongue, doesn't it?), if you're in the market for a big American bank that really has its act together, consider JPMorgan. It came through the financial crisis is excellent shape, due in no small part to the leadership of star CEO Jamie Dimon. And with a P/E of 9, I think it's also one of the great banking bargains out there. Find out more about the superbank in The Motley Fool's just published special report. In it, you'll learn where the key opportunities for JPMorgan lie, where its core growth will come from, all the potential business risks, and an analysis of its leadership team. Click here now for instant access.

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