Inside Financial Services

Sorry, Banks’ Living Wills Are Still A Bad Idea

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Bloomberg reports on the progress the big banks have made in preparing their government-mandated “living wills:”

Twelve banks granted the public a clearer look of their living wills Monday after regulators demanded they present more convincing plans this year for dismantling themselves in the event of failure. While the excerpts give investors and traders a better sense of what will happen in a crisis, the companies won’t learn for months whether the proposals are good enough to satisfy authorities and head off pressure to divest businesses.

Excerpts released Monday show the strategy at most of the big banks is to keep subsidiaries operating while their parent companies go to bankruptcy court and then sell some units. Many of the firms would cling to their core banks while shedding Wall Street operations that trade securities and make markets for clients. [Emph. added.]

Pure fantasy. The main purpose of a living will, remember, is to provide a roadmap that shows how an institution will proceed if it fails in the midst of a financial crisis. Absent a crisis, you don’t need living wills. Rather, in the case of a plain vanilla one-off bank failure, regulators will move in and (in the case of, say, Bear Stearns and Washington Mutual) resolve the situation via a government-assisted sale to a solvent buyer. In the case of the collapse of Wachovia, the resolution even happened without any government help whatsoever.

But during a panic, there aren’t necessarily any obviously solvent would-be buyers around. Everyone’s balance sheet is suspect! An orderly liquidation via a living will is supposed to be the next best thing. Mark me down as skeptical. If I’m reading this Bloomberg article right, for instance, come the next panic, several major broker dealers are going to be liquidated or sold all at the same time. JPMorgan reportedly plans to shrink itself by a third. Citi would shed $200 billion in assets Bloomberg reports.

So in the middle of the next panic, market liquidity is going to essentially vanish as the big banks shutter their market-making units, and banks’ ability to create credit is going to shrink as they downsize themselves. All of this, again, in the middle of a financial crisis. Thus the effect of these nutty living wills will likely be to take a bad situation and make it much, much worse.  But the taxpayers won’t be on the hook for any money, so Elizabeth Warren will be happy.

Policymakers need to face the fact that, in bankruptcy, banks are different than other kinds of businesses. An ailing, bankrupt manufacturer will get access to emergency liquidity and will be able to keep its operations running. But no liquidity provider is apt to provide emergency funding to an ailing bankrupt bank. It would risk putting itself under, as well. Only the federal government would be in a position to provide the troubled bank the liquidity it needs. So policymakers should come up with a way for that to happen without putting taxpayers permanently at risk. I think a new chapter of the bankruptcy code specifically to deal with financial services companies might be helpful—particularly if it an included a provision for an after-the-fact industry clawback to compensate taxpayers for the emergency liquidity they provided. (Suggestion welcome in comments section below, by the way.)

But anyone who thinks living wills are even remotely a solution is kidding himself.

What do you think? Let me know!

6 Responses to “Sorry, Banks’ Living Wills Are Still A Bad Idea”

  1. jsc173

    Tom, it’s just as you stated. I spent years at “Bank C” and was responsible for reviewing and assessing the stress testing done by many of their businesses in other countries.

    Whenever I would see the “liquidate poorly-performing portfolio” strategy, I would always ask, “To whom are you going to sell, assuming everyone else will be trying to sell?”

    Deer in headlights.

    This “living will concept” is what you get when you allow bureaucrats to design the ultimate set of nonsensical regulations, a/k/a Dodd-Frank.

    • Kerstin

      Vaduz is the name of the your Bank [;] and the capital of Lichtenstein.. As you say here and seeugstgd in twitter, Lichtenstein with only 34,000 population has 77,000 companies and many Banks with favourable .. terms and taxation, as I have .. found in Google. There are still some money Paradises on Earth. You look so relaxed sitting on the bench, dear Paulo Coelho. Vaduz must be a beautiful place as I have seen in the Google.. Dear Alexandra be alert with handsome professors who carry the.. aura of ..wisdom. ;]So dearest Paul from Austria, Paulo is always more in .. Rive Gauche!! ;] I used to use the perfume ‘Rive Gauche’ when my father was very sick and died.. After that time I cannot even smell someone near me with it The scent is a very strong sense relating to .. memories..LOVE,Thelma.

  2. Eric B

    Furthermore, what company in their right mind will take on the litigation risk and long reach after the fact from problems created by the seller. The government has proven their representations about no liability to buyers is not trustworthy.

    I’m not sure it’s a good thing for banks to have to sell off large operations at a time when you need market clout to maintain liquidity. The entities being sold are by definition short capital, and any available capital will be with the bank. So you are planing to sell undercapitalized units in a weak market without any likely buyers.

    It sounds to me like the plan won’t work during a crisis, but rather is a plan to break up the bank after the crisis has passed.

  3. CharlesT

    In my opinion the last financial crisis was a self inflicted wound resulting from an unforeseen (and would have likely been a short duration) liquidity problem that was compounded by an inflexible accounting standard (mark to market). This forced the banking system and regulators into a “panic mode” to quickly address paper driven capital inadequacies. These inadequacies have generally been shown to be temporary asset impairments. This rush to consolidate and liquidate destroyed many good business models as well as millions personal balance sheets. Governments should be there to provide stability in times of crisis not join in fray. A resolution agency with an industry funded contingency is the better solution; but, more importantly, the agency must also have the authority to suspend or moderate rules and thresholds that inappropriately drive us into a “paper number” crisis.

  4. SW Pilgrim

    Duh! A bona-fide “sale”, presumably of something of perceived value, is transacted between a buyer and a seller and settled via collected funds. Seems like about 90% of the “solution” got lost along the way. That’s OK, because we’ll have a wealth of experience of how not to react as we muddle through Greece. Why not consult the creative folks at Disney for an outline of the sequel?SWP

  5. Pat O'Brien

    The last crisis Hank Paulson couldn’t decide if he wanted to impose disclipline to suppress the moral hazard or to help the banks and FNM/FRE, thus missing an opportunity for a teaching moment. Given the choice, I’ll take the moral hazard every time if the alternative is a run on the bank which is what he got. This is and will always be the paradox within the system we have for recirculating money. It cannot be avoided as long as leverage is used and without leverage the price of credit would be usurious.

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