I’ve never been able to understand why regulators and financial-services reformers are so sure the “living wills” (which big banks are now required to have under Dodd-Frank) will be effective in helping bring about non-taxpayer-assisted resolutions of failing banks. Such wills almost certainly won’t be. And to the extent that they provide a false sense of security that all will be well in the event of the next crisis, their existence will almost surely make things worse.
A living will, if I understand correctly how they’re supposed to work, is a bank’s plan for how it will wind itself down in the event it runs into serious, life-threatening trouble. So this unit would be run off, say, that unit sold, and so on, all in a calm and orderly process until creditors and counterparties are made whole. Shareholders and debt holders might take losses, the justification goes, but the financial system won’t go into a panic, and taxpayers won’t have to get involved—and thus the country will be spared a replay of the 2008 panic and subsequent industry bailout.
All very sensible-sounding, right? Except one thing: it won’t work when you need it to. On the one hand, in the absence of a financial panic, if an ailing financial institution has to be resolved, who needs a living will in the first place? Rational, well-funded buyers will line up to pay a fair price for the good pieces of the business, the bad pieces will be wound down, and that will be that. Alternatively, if that same institution were to have problems in the midst of a panic, the living will would be useless. Why? During a panic, there would almost certainly be no buyers. They’d be too panicked! Or if they weren’t, their liquidity suppliers would be. Almost by definition, a panic means chaos, and you can’t plan for a future that’s chaotic, no matter how granular you think you’ve made your bank’s living will.
So, no, living wills won’t be much use. Worse, the process the government has set up for banks to develop their living wills is an absolute joke. The feds provide essentially zero guidance on what assumptions or projections banks should use in drawing their living wills up. Instead the banks operate in a vacuum. Then the government turns around and rejects the living wills submitted by all the eleven banks required to submit them. How is that helpful?
The trick to resolving shaky financial institutions during a financial crisis, it seems to me, doesn’t have so much to do with facilitating an orderly disposition of assets, but rather assuring a liquidity lifeline so that the resolution can even proceed. During the panic in 2008, that meant giving Morgan Stanley and Goldman Sachs each bank charters so they could have direct access to the Fed window and, later on, providing banks with TARP funding as a confidence picker-upper for their liquidity suppliers. Fannie and Freddie were swept into government conservatorship.
The objectionable aspect of all these measures (none of which I objected to, then or now) is that they amount to a bailout of private entities by taxpayers. The trick is to figure out a way to privatize the bailouts—no taxpayer dollars involved–then either let the entities fail or (as can happen) provide enough liquidity until the panic passes, and solvency is restored. You will have your own view on how this might work. For me, a good place to start would be a new chapter of the bankruptcy code that would apply to financial institutions. In the meantime though, relying on living wills to help solve the problem isn’t going to go very far.
What do you think? Let me know!