Publish the Secret Rules for Banks’ Living Wills

Regulators aren’t satisfied with the wills of five big firms—but they refuse to say what the criteria are.

By Hal Scott


The Federal Reserve and the Federal Deposit Insurance Corp. recently determined that five of America’s largest banks do not have credible plans to go through bankruptcy without relying on extraordinary government support. If these five firms— J.P. Morgan Chase, JPM -0.77 % Bank of America, BAC -1.66 % Wells Fargo, WFC -1.72 % Bank of New York Mellon BK -0.97 % and State Street—can’t develop “living wills” that satisfy regulators, then the Dodd-Frank Act authorizes the government to break them up as soon as 2018.

What led to their failing grades on living wills? It can’t be lack of effort: Every year, American banks can each spend more than $100 million and one million hours preparing them, according to the Government Accountability Office (GAO). The real reason for failure is that the banking regulators have not disclosed enough details about how they assess the credibility of a living will. This opaqueness casts serious doubt on the legality of the determinations—and the threat to break up the Banks.



The Administrative Procedure Act of 1946 lays out processes that agencies must follow. The law generally requires regulators to issue formal rules, subject to public comment and court review, for any actions that have a forward-looking, binding legal effect on the public.

Although the banking regulators publicly issued a general rule for the living-will process, they did not include standards for determining the credibility of a living will. For instance, the regulators might want a specific legal structure for the entire banking organization, or an estimate of the capital and liquidity necessary to avoid disrupting operations.

In recent years, banking regulators have provided guidance to all banks related to the assumptions that should be included in a living will—such as what entities should fail and how derivative counterparties would terminate their trades. Yet, as several banks have discovered, complying with these assumptions does not ensure passing the test.

To avoid announcing the standards by which they judge a living will, banking regulators would have to show that the determinations are made on a case-by-case basis and are not based on pre-existing standards. However, the evidence shows that regulators apply the same standards to all banks. The five that failed were dinged by regulators for many of the same reasons, including how they determined the appropriate amount of liquidity at operating subsidiaries and their legal-entity structure.

Banking regulators have consistent standards for determining the credibility of a living will, but they have chosen to keep their criteria confidential. That may be changing: In a March letter to GAO, representatives from the Federal Reserve and the FDIC said that they are now considering disclosing the details of their criteria. But disclosure of a fait accompli is not enough. The agencies must engage in formal rule-making, so the public can comment on the wisdom of the policies. This would actually enhance the likelihood of successfully resolving a large bank without extraordinary government support, for several reasons.

Given official secrecy, the market cannot adequately assess whether the country’s largest banking institutions can go through bankruptcy. Without market confidence there is a risk that, following the bankruptcy of the parent holding company, short-term creditors would withdraw their funding en masse. This would render the living wills, which generally aim to assure such a run will not occur, useless. It could also set off a market-wide panic.

Providing the public with the criteria for a credible living will, including the size of any assumed capital losses, would enable the market to accurately judge for itself. It would also allow banks to draft stronger living wills, not only to pass the regulatory test, but also ones that might actually be implemented in bankruptcy.

Further, following the process described by the Administrative Procedure Act would insulate the living-will policies from being invalidated by the courts. Formal rule-making would also assure banks that regulators cannot change the rules of the game each year without first notifying the public. This ensures that banks are not shooting at a moving target and that the living will process is more than an expensive regulatory excuse to break them up.

The proposition that these complex living wills could ever be successfully implemented is, at best, dubious. And the regulators’ secretive nature only increases the likelihood that they could fail. The Federal Reserve and FDIC should lift the veil and tell the public more about the process—before it is needed.


Mr. Scott is a professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation.

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