Inside Financial Services

Banks’ Living Wills Aren’t Going To Work

And the process for writing them is useless

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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!

11 Responses to “Banks’ Living Wills Aren’t Going To Work”

  1. Pat O'Brien

    The living will makes sense only as political theater. The Federal Reserve was created when the country learned that the only thing worse than a bailout was no bailout. I can understand the lack of historical perspective in Congress but the Fed has no excuse except as the instrument of an administration that has beat an anti-business drum since it came into power. We have not seen the last bad business decision, we have not seen the last financial panic and we have not seen the last of the government back-stopping the banking system.

  2. PureDakota

    I agree, with some reservations to whether even your solution would work. It’s clearly an improvment, but the reality is that Congress will do what the facts and the politics of the time dictate when a crisis occurs. It will not feel bound to stick to whatever resolution course has been approved in earlier times.

  3. jsc173

    I used to be a key player in a very large bank in determining what could “kill” the bank, establishing trip wires that represented the expectation of elevated risk (losses) and what to do when that happened.

    The problem was at least 60% of this exercise was all about a group of people around a conference room table coming to a consensus.

    In other words, group think.

    And, surprise surprise, everything that was feared to happen happened over the past 25 years and, while the planning helped (a bit) the bank still lost its shorts on more than one occasion.

    So, given we were thought to be state of the art in our risk management practices and we still failed pretty badly when the Black Swans landed, who in their right mind thinks this nonsense is anything more than some at of self-congratulatory exercise?

    • PureDakota

      jsc173 hit the nail on the head. The current exercise seems to be mostly to create the illusion we will have an orderly resolution to the next crisis.

  4. Waynor

    A living will presumably requires a living beneficiary. For instance, Bear Sterns could will everything to Goldman and J. P. Morgan could leave what is left after it fails to Wells Fargo, and so forth. It appears presently that Canadian Banks would make better beneficiaries. I certainly agree with the first statement of Mr. O’Brien and the conclusions in the essay by Mr. Brown.

  5. Tom Brown (yes, another guy with same name)

    After the multi-billion dollar settlements for past sins, mainly from companies they took over or bought (stupidly in the case of BofA), do you really think JPMorgan, Wells and BofA (and others) will ever step in and do the government a favor by taking over other large struggling companies in the next crisis? I think the next crisis would be ten times worse than the last one – as you mention above – there will be ZERO buyers available to help the government. Private companies won’t get burned twice.

  6. eto

    Agree that living wills will not be much help in a financial panic. But, if a company is experiencing difficulty and its regulators are proactive in dealing with the possibility of dismemberment before the problems are insurmountable, at least the company will have thought about how to divest business units and attempt to raise cash. The key would be moving soon enough on the contingency plans.

  7. Dan

    But a living will is an effort to privatize the liquidity line.

    oh well

  8. Pat O'Brien

    Tom Brown (the other one), the next time the savior banks will require explicit indemnification from the government.

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