Sheila Bair, the hard-charging former director of the Federal Deposit Insurance Corporation, stands at the center of three of the biggest debates in Dodd-Frank implementation.

Former FDIC chairwoman Sheila Bair. (Manuel Balce Ceneta/Associated Press)

As someone who knows the FDIC — which is actually the agency that takes down failing banks — she's in an unusually good position to know whether the law's resolution authority will work. These are the new powers the FDIC has in Dodd-Frank to impose losses and fail a financial firm (it’s what Barney Frank called “death panels” for financial megabanks). Bair has also been a vocal advocate for higher leverage requirements, which has animated the debate over the recent Brown-Vitter bill. And she was recently critical of the efforts by the House Financial Services Committee to repeal parts of Dodd-Frank that push swaps out of bank holding companies, even though she original opposed a stricter version of that language back in 2010.

We talked about all three of these topics; our discussion is slightly edited for clarity.

Mike Konczal: To start, how do you think Dodd-Frank is unfolding? Specifically, the rules for Title II and “resolution authority.”

Sheila Bair: We finalized most of the rules we could write on our own before I left, though they are working on further clarifications. I think the FDIC has come up with a viable strategy for resolving a large complex financial institution. This is their strategy of using a single-point-of-entry. The FDIC will take control of a holding company and put creditors and shareholders into a receivership where they, not taxpayers, will absorb any losses. This will allow the subsidiaries to remain operational, avoiding systemic disruptions, as the overall entity is unwound over time.

I think this is viable, and they’ve done a lot of great work, particularly coordinating with the Bank of England on the relative resolution regimes. I think bondholders are starting to wake up to the idea that their money is at risk and that they could take losses, which will result in greater market discipline. If you convince the market TBTF is over, debt spreads will go up for large institutions. And you are seeing that happen a bit already. There’s a lot of work left to be done, but so far I’d give implementation a pretty good grade.

 It strikes me that coverage of resolution authority is often very political, with many people making up their minds on whether it will work from before the bill even passed. As such, it’s really difficult to understand if a stronger, versus a weaker, set of rules are being written.

We worked hard to make sure taxpayer bailouts are completely prohibited. I think the language is very tight on that. One of the things that frustrates me with critics of Title II is that they perpetuate the myth of Too Big To Fail by insisting that the government is still going to do bailouts, notwithstanding clear language in Dodd-Frank to the contrary. And that just continues the moral hazard by reinforcing market perceptions that the big institutions won’t be allowed to fail.

There are some critics who think just the very act of FDIC being involved, especially with the ability to provide emergency financing, is a de facto bailout and puts taxpayers at risk.

A couple of things. First, the FDIC process is essentially a bankruptcy process. We follow claims priority religiously — you would never see the FDIC haircutting secured creditors and bailing out unsecured creditors as they did with the GM bankruptcy. In fact, Dodd-Frank is more harsh than bankruptcy in that key board members and top managers have to be fired with mandatory clawbacks of their pay.

Second, I pushed very hard to get a pre-funded reserve for working capital to support the FDIC’s resolutions work. This would have been a $150 billion dollar reserve paid for by financial institutions over $50 billion in size. We got it through the House, but it was opposed in the Senate. Ironically some of the folks who like to bash Title II as a bailout mechanism opposed this industry-funded reserve.

This pre-funded reserve was replaced in the Senate with a line of credit from the Treasury Department that the FDIC can tap into for working capital for a resolution. If it is used, it is repaid off the top as the failed institution is restructured and sold back into the market. The government’s claims take priority over everyone else. If the privately held debt and equity aren’t sufficient to absorb losses, then any shortfall is paid for by an assessment on the industry. There’s no way taxpayers will be taking losses with this kind of mechanism. Based on the FDIC’s past experience, I think it is extremely unlikely that losses on a Dodd-Frank resolution would exceed equity and unsecured debt. And even if that did happen, there’s an immediate assessment on the entire industry. It wouldn’t be paid by taxpayers.

That’s another reason why the industry itself should want to make sure that effective rules and meaningful resolution plans are in place for an orderly failure. Because if the banks don’t give the regulators what they need to be prepared, it will not only be more expensive for creditors, but also potentially for the industry as a whole.  Of course, the risks of an industry assessment are reduced if the megabanks have thick levels of equity and unsecured debt.  I believe the Federal Reserve Board will move ahead with rules to increase minimum equity requirements for megabanks and also set minimums for unsecured debt.

 I personally like the industry assessment. If resolution authority is invoked to preserve stability and prevent panics in finance, then any costs should fall on the financial industry as a whole.

How is the international coordination going? Many point out to the international component as being the hardest part of this procedure.

 For the five biggest U.S. megabanks, about 80 percent of their foreign operations are subject to the jurisdiction of the UK. So you have the lion’s share of it right there with the Bank of England. Another area, where industry has not taken a role, is to amend the documentation that is used by derivatives dealers worldwide to make sure that derivative contracts have built-in legal recognition of the FDIC’s resolution authority. That could be fixed very easily if ISDA, an industry group, would amend its standard documentation.

 You’ve written about how banks should have higher leverage ratios. One thing that strikes me in the argument about higher leverage ratios is so many regulators agree with you. Fed Governor Tarullo even wrote a book on Basel II critical of this. Given that so many people support this, why haven’t higher ratios been written by regulators?

I’ve spent a lot of time advocating for a leverage ratio. Back in 2006 when I first joined the FDIC as chairwoman, we were fighting off an effort by other regulators and industry to get rid of a leverage ratio and just go with the risk-based modeling done internally by banks.

We had to fight hard to get a leverage ratio in the Basel III accord. It frustrates me when people bash Basel III, because Basel II is really where the problems were. Basel III was designed to fix many of these problems. After a lot of fighting, we secured an international accord on having a non-risk-weighted leverage ratio in the final product.

This is the good news. The bad news is we could only get to 3 percent. The Germans and the French in particular really didn’t like it, and 3 percent is as high as we could go. So that was a compromise. A lot of regulators have said it should be higher though, and there’s a consensus among independent thinkers and academics that there’s still too much leverage in the financial sector.

The Basel accords are meant to be a floor, not a ceiling. Regulators in the US could take the 3 percent leverage ratio proposed in the rules and put in 8 percent instead. I’m hoping that US bank regulators will do this.

Right. And that can be done during rule-writing by regulators, which means they wouldn’t even have to go back to Congress.

Absolutely. There’s no question about their authority to do that.

 I understand why the banks don’t want a higher leverage requirement. If our regulators imposed it themselves, how much international pressure would they come under from Europe?

If our regulators promulgated a higher leverage requirement, you’d put more pressure on Europe to implement the Basel III leverage ratio and even raise it. I think the UK will go with a higher number. Right now, continental Europe is floundering on Basel implementation. The leverage ratio is on the back burner. If we upped the 3 percent in the US,  it would put great pressure on them. Right now their banks are too leveraged and it is hurting their economy. Strong capital is a competitive strength, not a competitive weakness.

One thing I’ve noticed that is that many people argue that since resolution authority is coming along well, and taxpayer-funded bailouts look less likely, there’s no reason to increase capital requirements. But you argue both — FDIC is doing well and we really need higher leverage ratios. How does that work?

Just because we now have a process to let megabanks and financial firms fail without taxpayer support doesn’t mean we shouldn’t be trying to prevent failures. The best way to prevent a failure is to get them to hold more common equity. And if they do fail, they have a bigger cushion of protection for bondholders and other unsecured creditors. So these two make each other stronger: more capital means less likelihood of a failure, and it also means more loss absorption capacity if the FDIC is forced to act. They go hand in hand, and complement each other.

 A controversial piece of Dodd-Frank was a provision called Section 716, which would have pushed derivatives known as swaps outside bank holding companies. A much more limited version of it was included in the final bill. Recently the House Financial Services Committee has voted to repeal the limited version that passed.

You originally opposed the full measure, though now you came out against the bill by the House to repeal the limited version of it. How has your thinking on this issue evolved since Dodd-Frank passed?

During Dodd-Frank the original proposal was to push pretty much all swaps outside of bank holding companies. I didn’t think that was necessary or appropriate. To push them completely outside regulated entities didn’t make much sense to me.

Since Dodd-Frank, unfortunately, the trend has been to move this activity from the investment banking affiliates, which do not use insured deposits, into the banks where the activity can be funded with cheap, FDIC backed deposits. Section 716 would at least keep certain credit default swaps outside of insured banks. I don’t understand why conservatives would be pushing this so hard. Derivatives have many legitimate functions, but they can be high-risk and poorly understood because of their complexity by bank managers and even regulators, as we saw with the London Whale debacle - so keeping them outside of insured banks and making the market fund them is the way to go. This will increase market discipline and protect the FDIC.

Longer term, government policies toward financial derivatives need to be fundamentally rethought.  I’m concerned that members of Congress act on these issues without full understanding of the ramifications.  If we are going to revisit derivatives regulation, I’d go in the direction of more market discipline and disclosure, rather than letting big derivatives dealers use insured deposits to support their high-risk operations.  This market is amazingly complex and potentially destabilizing. Yet Congress keeps showering special benefits on this industry.  Derivatives get breaks under the tax code, under the bankruptcy code, and under capital and margining rules. They have all this preferential treatment even though they can be quite destabilizing. I’m not sure if we have the derivatives regulations right, but repeal of Section 716 moves in the wrong direction.

But regulators leave the door open to this kind of industry-driven legislative mischief when they fail to finalize the rules and leave these issues dangling. I was surprised and disappointed by these votes in the House. In an area as complex as this, I wish Congress would at least wait for the regulators. But the regulators need to use their authorities.

Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on twitter here.