Why the ‘Living Wills’ of Top U.S. Banks Failed the Test

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Eight years after the Great Recession, the top eight “systemically important, domestic banking institutions” in the U.S. are still not ready to cope with the aftermath of another financial crisis. The banks had been asked to submit plans to show how, if crisis struck, they would wind up in an orderly manner that does not necessitate government bailouts or cause panic in the financial system.

That was the upshot of findings jointly released on April 13 by the U.S. Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). The two agencies found the resolution plans – called “living wills” — filed by five banks as “not credible.” They differed on the readiness of two other banks. They did not fault the credibility of the plans of the eighth bank, but nevertheless found shortcomings that need fixing.

More broadly, the findings underline a transformation underway in financial regulation to make it more stringent and probing than ever before, according to experts at Wharton and the University of Michigan. However, sustained advocacy is required to combat efforts by politically backed interest groups to undermine bank supervision and consumer protection, they said.

The findings of the regulators are in line with the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires banks to submit plans to facilitate an orderly resolution under the U.S. Bankruptcy Code.

“Dodd-Frank is creating a radical transformation in the way that we do bank supervision, which had been a stable set of institutional arrangements for about 150 years since federal bank examination began after the Civil War,” said Wharton professor of legal studies and business ethics Peter Conti-Brown. He recently authored the book The Power and Independence of the Federal Reserve.

The way Dodd-Frank is panning out challenges critics “who see regulators — the Federal Reserve and the FDIC — as ‘captured,’” said Conti-Brown. “Regulatory capture” is a term used in academia and the popular press to suggest that regulators are unduly influenced by the interests of the entities they regulate.

“There is, across the board, more stringent supervision with much more probing questions [than in earlier times],” said Michael S. Barr, professor of law at University of Michigan Law School. Barr formerly served in the U.S. Treasury department where he was assistant secretary for financial institutions; he was also a key architect of the Dodd-Frank Act.

“[Regulators] are [now] poking and prodding at the balance sheets of these firms to see what happens in stress,” said Barr. “This ‘living will’ or resolution planning process forces firms to think much more clearly about their organizational form, to align their business with their legal entities and to think carefully about how they can operate and then be wound down in the event of a crisis.”

Conti-Brown and Barr discussed the implications of the regulators’ findings and ways to address continuing challenges for bank supervision on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

What the Findings Mean for Banks

The banks whose 2015 resolution plans were found to be “not credible or would not facilitate an orderly resolution” are Bank of America, Bank of New York Mellon, JP Morgan Chase, State Street and Wells Fargo. In the case of Goldman Sachs and Morgan Stanley, either the FDIC or the Federal Reserve found their plans not credible enough. Neither agency found Citigroup’s resolution plan as “not credible or would not facilitate an orderly resolution” under bankruptcy laws, but they did find shortcomings for the bank to fix.

Essentially, the regulators have told the banks that their internal models for computing relationships with various counterparties and the way they structure their assets and liabilities “don’t work,” Conti-Brown explained. “That is very different from what we saw before Dodd-Frank, when the question was: ‘Do you have internal models to make these internal evaluations?’ If the answer was ‘yes,’ then no questions followed.”

“All eight of the firms have to go back to the drawing board,” said Barr. He clarified that in determining the credibility of the living wills, the Federal Reserve and the FDIC have not suggested that these firms will have to be bailed out or that these firms are close to liquidation.

“[Instead, the firms] have more work to do, particularly with respect to crisis planning and liquidity so that [in the event of a crisis], they can be safely dealt with and wound down without causing panic.”

Conti-Brown disagreed with critics who suspect that the regulators’ findings are a validation of the theory that the eight banks are too big to fail, and that a fresh financial crisis would see a repeat of TARP. He explained that in the event of a crisis, Dodd-Frank’s creation of the Orderly Liquidation Authority (OLA) would serve as “a backstop” if conventional bankruptcy processes do not work for troubled banks. That liquidation authority also has several mechanisms to ensure that wholesale government bailouts will not be required, he added.

“The government is telling these banks that they need to make significant changes so that they can go through bankruptcy [if they fail],” said Conti-Brown. “Absent those changes, orderly liquidation authority is triggered. It’s not correct to say that you have to make these changes and if you don’t, we will see endless bailouts. It’s important to see that progression between living wills, bankruptcy and the Orderly Liquidation Authority (OLA) – that’s the model that the government and the banks are working on.”

Each financial institution cited for shortcomings in their plans must “remediate its deficiencies” by October 1, 2016, the regulators have said. Failure to do so could attract higher capital requirements and restrictions on growth or activities, they warned. The deadline for the next full plan submission for all eight financial institutions is July 1, 2017.

Safer Banking System, but Not Safe Enough

The Dodd-Frank regime has already delivered on some fronts, according to Barr. He maintained that the financial sector is “a lot safer today” than it was at the height of the financial crisis in 2008. “[We have] double the amount of common equity in the system, cushion against lawsuits and supervision of the largest firms by the [Federal Reserve] and an Orderly Liquidation Authority so that those firms can be wound down in the event of a financial crisis without creating a panic and without having a taxpayer bailout,” he said. However, “there is still a lot of work to be done to make sure that they can be dealt with in a financial crisis,” as revealed by the report of the regulators, he added.

Conti-Brown drew Barr’s attention to criticism of Dodd-Frank. “Doubling the amount of common equity in the system is not as impressive as it sounds, because when you double what is virtually nothing, you still don’t have very much of anything,” he said. “Even with the living wills, stress tests and other regulatory tools, the OLA and its resources would be quickly exhausted in the event of a crisis.”

“[To say that] the financial system is safer isn’t the same as saying that it is safe enough,” said Barr. “Much more work needs to be done to make the financial system safer, to make it fair and to make it better harnessed to the needs of the real economy.”

In order to become more resilient and safer, the financial system needs stronger capital rules and better supervision, among other measures, said Barr. Much work needs to be done both in the formal banking sector, such as in issues relating to liquidity, and in the shadow banking sector, such as reforms governing securities lending transactions, he explained. All the same, he said, “It would be a mistake to say the system is still the same and it hasn’t changed and that we haven’t made any progress.”

Fears of Collective Amnesia

Even as further reforms get implemented, “banking security will always be a work-in-progress,” Barr noted. “When a long time passes without a financial crisis, people forget the causes and consequences of the financial crisis and collective amnesia descends. They say we don’t need as much capital, and it is not as risky as we think — and that is when you get into enormous trouble.”

Guarding against that “collective amnesia” is critical to ensure the strength and safety of the financial system, Barr said. While living wills and stress tests are one way of achieving that, it is also necessary to get the general public to focus on risks in the financial system, without leaving that job to the industry and regulators, he added. He pointed to recent positive steps, such as the creation under Dodd-Frank of the Office of Financial Research to gain an independent view of the risk in the financial system.

Conti-Brown pointed to the risk of interest groups attempting to whittle down the scrutiny of stress tests and living wills and pushing for deregulation of banks. “The most vexing aspect of sustainable financial regulations is that when the public attention shifts, those who are best organized to get their interests heard [will] be successful,” he said. “So I wonder if stress tests and living wills will be with us 20 years from now; I hope that they are.”

Barr agreed that those forces that attempt to undermine bank regulation pose a risk. “Congress has tried to repeal many elements of the Dodd-Frank Act, and you will continue to see efforts to repeal [and] restrict regulation, go after stress testing, go after living wills, go after higher capital requirements, try and weaken the Consumer [Financial] Protection Bureau, roll back securities reforms and investor protection, [and] eat away at derivates reforms — we’ve seen these efforts already,” he said. “The battle over the Dodd-Frank Act didn’t end when it passed — it continued.”

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