Personal Wealth Management / Market Analysis

Banks Fail Vague Test, Blame Vagary

Is the Fed about to cut off a traditional lifeline for banks?

No word on whether banks' living wills use such fancy script. Photo by Getty Images.

Here is a rough approximation of how the dialogue between banks and regulators has gone since the Fed and FDIC gave 11 big banks an F on their living wills: "You're vague." "No, you're vague." "Well you're not transparent!." "No you're not transparent!" "Yah, well, you're the vaguest and we make the rules-no lender of last resort for you! So there!" At least, that's how we interpret the latest rumblings from the ever-reliable unnamed sources "familiar with the process," who said banks shouldn't include the Fed's discount window in their list of things they can use to make their potential failure potentially more orderly during a potential crisis in the potential future. Now, if the Fed really does close the discount window during the next crisis, it could be really bad, and we'll get to that shortly. But for now, the news simply underscores what an opaque exercise these living wills are-and why investors shouldn't put much stock in them.

The living will, for those not familiar, stems from 2010's Dodd-Frank Act, part of which requires banks annually submit a plan for the "rapid and orderly resolution in the event of material financial distress or failure of the company." This is based on the belief that:

  1. Lehman Brothers' bankruptcy triggered the 2008 crisis (wrong)
  2. That Lehman having a written policy & procedure called "What to do if we have to write down assets so deeply no one will take them as collateral anymore and we have to go bankrupt even though our assets exceed liabilities" would have helped restore sanity to markets (wrong)
  3. And that Lehman Brothers circa 2005 (or whenever) would have had the foresight to know the preceding should be the focus of their "in case of our untimely demise" strategy. (Also wrong.)

But Dodd-Frank was written by politicians, and politicians aren't often accused of possessing simple logic and an accurate understanding of the US financial system. They know Lehman's bankruptcy took years (and counting) to resolve, and they decided saying they could fix it might score some Brownie points with voters. So now banks submit living wills annually, and one year later, the feds release their report cards.

This year, the banks got a fail. After spending a year reviewing the tens of thousands of pages submitted, the Fed said the biggest banks' wills had "shortcomings." The FDIC called them "not credible." As FDIC Vice Chair Thomas M. Hoenig put it: "Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn't require unrealistic assumptions and direct or indirect public support." What exactly "direct or indirect public support" means has been the matter of some debate over the past two weeks. Some said big banks weren't properly accounting for how foreign regulators would treat their international subsidiaries-though what "properly" means is really anyone's guess, since no one knows whether foreign authorities will seize subsidiaries of failing US banks.[i] Others said banks made too many rosy assumptions about how counterparties in their derivatives contracts would behave-the subject of another simmering regulatory debate.

And now the discount window thingy. The discount window is the Fed's primary facility for serving as lender of last resort-it's the place banks go for cash when no one else will lend to them. It's there to keep banks from going under simply because they can't get overnight funding to cover daily obligations-a lifeline until things normalize. Serving as lender of last resort is largely why the Fed was created in 1913, when banks and the US government were desperate to prevent a repeat of the Panic of 1907.

For 95 years, the discount window provided emergency funds to the banking industry. But then 2008 happened. Bear Stearns-the first to fall-couldn't tap the discount window. Only banks or bank holding companies can tap it, and Bear was an investment bank. Ditto for Lehman. Compounding problems, the Fed outsourced most of its crisis management responsibilities to the Treasury, resulting in a hodge-podge of conflicting approaches-marrying off Bear and later WaMu to JPMorganChase, pairing failing Wachovia with Wells Fargo, nationalizing Fannie and Freddie, then letting Lehman fail. Oh and then nationalizing AIG. This inconsistency, not the actual Lehman bankruptcy itself, is what drove the panic.[ii] When the dust settled, all the big investment banks had either failed or reorganized as bank holding companies, allowing them to finally tap-wait for it-the discount window!

So you can see why banks might want to include this facility in their plans. It exists to prevent them from going bankrupt unnecessarily. Yank this away, and the US banking system goes back to the 19th century.

Now, it is far from certain-and highly unlikely-that the Fed stops being lender of last resort. It wouldn't be unheard of-a few months ago, Europe accidentally wrote a law declaring banks insolvent if they used the Bank of England's last-resort lending facility. (Last we read, a fix is pending.) More likely, in our view, is that the Fed is just trying to be seen as tough on banks after Massachusetts Senator Elizabeth Warren sparred with Fed Chair Janet Yellen over living wills during Yellen's Senate appearance last month, essentially calling Yellen soft. Now? Not soft.

This highlights just what's wrong with the living will exercise. It's a political tool, created by politicians, used for political grandstanding, and likely of no use when the next crisis arrives. If banks can't use basic, reasonable assumptions like having a lender of last resort, how realistic can these plans possibly be? Plus, no one today has any inkling of what the next crisis will look like. You can't plan for the unknown.

In our view, the US financial system would probably be better off if politicians scrapped living wills entirely. One, having a plan in place and then inevitably deviating from it causes more uncertainty, not less. Two, if shareholders and creditors know a bank has a written policy outlining exactly how and when they'll get whacked if things go south, then they have an incentive to accelerate a run-that generally causes panics, rather than resolving them. Three, the financial system functioned fine for 95 years sans living wills. Four, the problem in 2008 was crisis mismanagement by US officials. Hey! Maybe they should just write themselves a plan instead! We know what step 1 can be: Let the Fed do its lender of last resort thing.

For investors today, this debate is largely academic. There are potential ramifications worth considering, but they aren't an issue in the here and now, and the Fed could easily clarify matters down the road. For now, the takeaway is simply this: Living wills-and the feds' opinions-are largely make-believe. If you want to try to measure the banking system's health, there is plenty of other, more transparent, real-world information at your fingertips.

[i] This all sort of stems from the failure of Icelandic bank Landsbanki in 2008, which had a big UK presence through its British subsidiary Icesave. UK savers were wiped out when Icesave went under, but when Iceland nationalized the failed bank, officials didn't step up and repay insured depositors. UK authorities invoked anti-terrorism law to freeze all Icelandic bank assets in order to goad them into paying, and a four-plus-year legal battle ensued. The general consensus seems to be that if the Bank of England had just seized Icesave when things at Landsbanki looked dicey, the whole kerfuffle could have been avoided.

[ii] And we won't bore you with this yet AGAIN, but without FAS 157-the mark-to-market accounting rule-being applied to illiquid assets, none of this would have happened in the first place.

If you would like to contact the editors responsible for this article, please email

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Get a weekly roundup of our market insights.

Sign up for our weekly e-mail newsletter.

Image that reads the definitive guide to retirement income

See Our Investment Guides

The world of investing can seem like a giant maze. Fisher Investments has developed several informational and educational guides tackling a variety of investing topics.

A man smiling and shaking hands with a business partner

Contact Us

Learn why 100,000 clients* trust us to manage their money and how we may be able to help you achieve your financial goals.

*As of 12/31/2021. Includes Fisher Investments and its subsidiaries.

New to Fisher? Call Us.

1 (888) 823-9566

Contact Us Today