Taking the "Bank" out of Bankruptcy
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This post expands on the differences between typical bankruptcies and FDIC receiverships. The FDIC has a lot of authority when it comes to bank failures, including putting a bank into receivership in the first place. Critics have stated that a Chapter 11 process would result in more prudent risk management and oversight from lenders and investors. The counterargument is that bank failures, especially large ones, are a high stakes deathmatch. We lay out the differences for you to decide and give our opinion at the end.
The next edition of Cap Stack will cover another stressed/distressed situation. We covered Redfin last week — check it out if you missed it. If there are specific distressed investing topics you’re interested in learning more about email us back or drop us a comment and we’ll be happy to cover them.
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— Cap Stack Team
The Federal Deposit Insurance Corporation (FDIC) was established in 1933 to stabilize the U.S. banking sector in the midst of The Great Depression. In addition to its role as an insurer and regulator of banks, the FDIC has special powers to manage bank failures through conservatorships and receiverships.
In the U.S., banks cannot file for bankruptcy protection the way non-bank companies can. Chapter 11 is not applicable for bank entities. An FDIC seizure of a bank may appear similar to a bankruptcy process and does have many of the same rules, but there are major differences. The FDIC along with the bank’s primary regulator makes the determination for when a bank has failed. The FDIC has the power to remove and replace a bank’s management and board of directors as well as eliminate shareholders’ rights.
Creditors in bankruptcies can influence, vote on, or object to decisions. In an FDIC receivership, creditors do not have this ability.
The FDIC puts failed banks into receiverships to effectuate a sale to another institution (identified in advance, where possible). An acquiring bank will assume the failed bank’s deposits and potentially some other liabilities. The FDIC may look to provide sweeteners to these deals to incentivize acquirers who may be plugging their nose when assuming these liabilities. The failed bank’s assets are sold off as part of the sale or by the FDIC in a process that may take months or years.
Traditional bankruptcies require the approval of creditors. Even a “cramdown” requires some creditors on board, and creditors can appeal to the bankruptcy judge.
Cramdown: when a bankruptcy court forces a creditor class to accept the terms of a reorganization plan despite creditors’ objection to the plan.
In a bank receivership, the FDIC swoops in like G.I. Joes, seizes the bank, and aims to make insured deposits available within two business days. The FDIC might seize a bank on a Friday and have it reopen on Monday as part of a new bank. This sort of speed is unheard of in traditional bankruptcies, and is only possible because of the power awarded to the FDIC as a government agency.
With great power comes great responsibility, as they say. The FDIC markets failed banks to healthy banks. Its goal is to maintain financial system stability and public confidence. The FDIC is also required to resolve bank failures using the least costly resolution to minimize losses to the Deposit Insurance Fund (DIF). The DIF is is funded by pooled fees from U.S. banks. If the DIF is insufficient the FDIC can borrow from the Treasury and pay it back through future assessments on banks.
Non-depositor creditors and shareholders are of lower priority. Depositors have statutory priorities over other unsecured claims. The FDIC will optimize for making depositors whole.
Under the Federal Deposit Insurance Act (FDI Act), the priority of proceeds are:
Secured claims
Admin expenses of the receiver
Insured deposits
Uninsured deposits
Other general or senior liabilities
Subordinated obligations
Shareholder claims
The practical implication here is that after deposits, other claimants do not receive much if any recovery.
Insured depositors are paid in full “as soon as possible”, while uninsured depositors are subordinated in priority and may need to wait.
Bank failures can be a highly political situation. Government officials have gone out of their way in to point out that shareholders and debtholders of failed banks are not being protected by the government. The FDIC’s mandate for a least-cost resolution amplifies this effect, calling for the FDIC not to take actions that increase losses to the DIF to protect non-depositor creditors. The FDIC resolution must be the lowest total expected FDIC expenditure. Exceptions could be made, but only for systemically important institutions.
Depositors are, rightfully so, the last to take a loss. Shareholders and debtholders are sophisticated players who are putting on risk when extending capital to a company. Depositors on the other hand cannot be reasonably expected to become financial institution experts (although some prudence in where funds are deposited should be encouraged).
You need not look far back in history for examples of creditors getting torched in highly politicized situations. The Detroit, Puerto Rico, and Chrysler bankruptcies are just a small handful of examples.
Despite having capital at risk, recent bank failures went largely unnoticed by many investors until it was too late. First Republic Bank (FRC) was underwater on its equity based on the company’s own reported fair value measurements as early as Q2 2022. With the last banking crisis having been over a decade prior to today and years having gone by with any bank failure at all, many market participants misjudged the extent to which larger banks were at risk.
Bank Holding Companies
Bank entities go through the FDIC receivership process but non-bank entities are still awarded bankruptcy protections. That’s why SVB Financial Group ended up in Chapter 11 even after SVB’s receivership.
That does not mean a bank holding company is free from all obligations. The FDIC is awarded advantages per Section 365(o) of the bankruptcy code. You see, bank entities have to maintain minimum capital ratios (CET1, Tier 1, etc.) per regulations. If a bank holding company enhances its own financial position at the expense of the bank subsidiary’s capital, taxpayers become the bagholders. The ultimate obligation is a contentious point that can be litigated, but when it applies the holding company must satisfy its obligations or be forced to convert to Chapter 7 and liquidate.
Receivership Process at a Glance
The FDIC receivership process involves:
Marketing the failed institution
Closing the failed institution
Repayment or assumption of insured deposits
Minimizing costs to the DIF (thereby requiring maximal recovery value based on cost, timing and risk)
The FDIC tries to enter a purchase and assumption transaction before a bank is put into receivership. This transaction involves a healthy bank purchasing the assets of the failed bank and assuming at least the insured deposit liabilities.
As many assets are sold as quickly as possible and distributions are made to creditors (the largest of whom are depositors). Assets that remain are continued to be marketed after the receivership.
The FDIC has the power to transfer any asset of the failed bank without approval or consent. The FDIC in essence acts as both the trustee and bankruptcy judge.
Cap Stack’s opinion is FDIC receivership is better for depositors than a Chapter 11 process would be due to the speed with which the FDIC is able to act and the cost savings (bankruptcies are expensive!). For basically every other constituent including stakeholders of non-bank entities, receivership will probably result in a bad outcome.
Everyone loses money, including the FDIC (taxpayers)! Except Jamie Dimon over at J.P. Morgan — he swoops and picks up the good parts.
Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.