In Case of…

What was typical for individuals is now also for big banks, thanks to Dodd-Frank. Source: Getty Images

Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed another milestone last week as the Fed released updated drafts of banks’ “living wills”—plans for their “orderly” dismantling in the event of failure. To regulators, this is a key step toward “fixing” too big to fail. In our view, however, it’s another instance of regulators trying to accomplish the impossible—de-risking the financial system—and adding more bureaucracy than “safety.” Complying with the new requirements probably isn’t a material headwind for Financials, but investors shouldn’t assume the existence of living wills means all will be hunky-dory the next time the banking sector comes under fire.

Dodd-Frank requires the biggest banks to release a two-tiered worst-case-scenario plan annually. The first tier, recovery, outlines the bank’s plan for restoring its financial health after a hypothetical financial crisis. The second tier, resolution, is the “in case of my demise” plan—a guide for regulators to unwind the institution if it fails. Essentially, it’s regulators’ latest attempt to prevent more taxpayer-funded bailouts—or, if you prefer, “fix” too big to fail. The intent—addressing moral hazard in banking—is benign enough, but the prescription seems based on a misdiagnosis of 2008’s financial panic. Yes, some of the biggest US banks received taxpayer money then, but their size wasn’t the issue—nor was their business models. Heck, none were fundamentally insolvent! They just couldn’t get short-term funding on open markets after $2 trillion in exaggerated and unnecessary write-downs rippled throughout the banking system.

Thanks to FAS 157 (mark-to-market accounting), banks had to mark assets on their balance sheet to the current market value—including illiquid securities they never intended to sell. So whenever a bank dumped mortgage-backed securities at bargain basement prices, everyone else had to write-down the value of similar assets accordingly, taking paper losses. This forced many to raise significant capital, and as the crisis escalated, getting cash got more and more difficult. So after the Feds’ confused responses to Lehman, AIG, Fannie and Freddie panicked investors and credit froze, the government stepped in. Even banks that weren’t in jeopardy of bankruptcy received bailout funds courtesy of TARP investments—many against their own wishes. Said another way, the banks weren’t really “Too Big to Fail.” The government just thought they were. And so they ordered the biggest banks to create a guide for regulators to use the next time they “fail.” Even though none failed—this is a bit head scratching.

Overall, this new requirement shouldn’t create material headwinds for Financials. Writing the living wills might be a small burden, but it shouldn’t drag much (if at all) on profits or business (though the accompanying headaches might boost banks’ ibuprofen expenditures). But it also might not help much the next time things go south. Plans are just plans—they aren’t set in stone. What banks ultimately do when faced with failure will depend on the conditions and environment, which are impossible to game today. Simply, there are too many unknown variables. For example, many of the banks plan to orchestrate asset sales. And when a bank is of sound mind and body, there might be many willing buyers, ready to ante up! But how can they guarantee they’ll find a buyer in a panic? How do they know there will be a taker for any assets they plan in advance to offload? It all depends on market conditions at the time, including what drives the next crisis—something no one knows today. That’s true even with the requirement to update their living wills yearly—we rather doubt banks in September 2007 would have had the foresight to say, “in the event we take huge unnecessary write-downs and can’t get overnight funding after the government bungles the failures of Lehman, AIG and Fanny and Freddie, we’ll do X.” Perhaps that’s why one bank came up with a simple (bordering on cheeky?) plan and called it a day. If they go bankrupt, they’ll, well, file for Chapter 11 bankruptcy. They’ll recapitalize if they can, and banking operations will continue while they go through the Chapter 11 process.

Moreover, even if living wills were more useful, they still aren’t guaranteed to prevent bailouts. Governments could very well still feel compelled to step in and rescue some banks if they thought it necessary to prevent some theoretically worse outcome—just as they did in 2008. Even if banks have sound plans to limit the economic fallout of their demise, officials might decide the political costs are too dear. Which underscores how “too big to fail” is more of a political than economic issue, though that’s a topic for another day.

In short, living wills seem to be a solution in search of a problem. But that doesn’t mean banks will get caught with their pants down if things get dicey again. Balance sheets are far healthier today than at any point in recent history—banks have amassed huge liquidity buffers, with many of the largest institutions capitalized in excess of Federal requirements. Banks today are profitable and seem poised to get increasingly so when the Fed stops depressing yield spreads via quantitative easing. All this should boost Financials stocks regardless of how feckless living wills might prove in the far future. And in the foreseeable future, the next 12-18 months, consider that profitable banks rarely need government bailouts.