Market Analysis

Living Wills Are No Way for Banks to Die

Bank living wills likely won't prevent future bailouts or make the next crisis less severe.

No one likes planning for their demise. Not you. Not us. And not banks, if the Fed and FDIC are to be believed. Last week these regulators told five big banks to go back to the drawing board and revamp their "living wills"-plans drafted annually to serve as a "how to" manual for unwinding a big bank if they fail. In letters to these banks, regulators said their living wills failed to credibly prove they could fail in a hypothetical crisis and be unwound without touching taxpayer money. As with anything even just tangentially related to bank failure and 2008, the media is making a big deal about this, echoed by politicians. They claim these banks "are large enough that any one of them could crash the economy again if they started to fail and were not bailed out," "If these banks don't fix their problems over time, then regulators need to break them apart," and "I continue to think that the largest banks in the country are too big to fail." But whatever your thoughts about big banks posing a systemic financial risk, practically speaking, living wills are powerless. They are regulators' feckless attempt to make banks plan for an unknowable future that adds little-to-no clarity about the present.

The idea stems from 2008's financial crisis. Many believe failing big banks-and difficulties unwinding failed banks like Lehman-caused the crisis to intensify and cascade from one bank to another. Politicians concluded Chapter 11 filing alone was insufficient, surmising a law requiring the biggest banks to plan ahead for an orderly wind down in the event they fail will help prevent or mitigate another crisis, forestalling the "need" for government bailouts. Hence the requirement for the eight biggest banks to draft "living wills." These plans hinge on the current-day understanding of allegedly risky parts of that business. The Fed and FDIC then review and independently grade the plans for "credibility." If either of them deem the plan credible, the bank passes. If not, they must resubmit. If they fail again, they could face higher capital requirements, stricter leverage limits or even, in extreme cases, forced divestment of certain businesses.

This year, both the Fed and FDIC gave failing grades to five banks: JPMorgan Chase, Bank of America, Wells Fargo, Bank of New York and State Street. This forced them to sufficiently rework their living wills by October 1. So what specifically was insufficient about these five banks' resolution plans? Bloomberg's Matt Levine summarized:

But remember that the evidence for this is things like JPMorgan's lack of a detailed daily cash flow statement for its eighth day after bankruptcy. Or that Bank of America's plan to wind down its derivatives portfolios "lacked detailed portfolio information and specificity regarding implementation of the wind-down." Or the insufficiency of Goldman Sachs's "triggers designed to escalate information to senior management and its board through multiple phases as the condition of the firm worsens." Or Wells Fargo's lack of "legal entity rationalization criteria" -- that is, rules about not creating too many subsidiaries -- that "not only provide for the rationalization of current entities, but also provide for adequate controls for future strategic actions."

Now, there is a lot of jargon in those rationales, but there is one common thread: They are arbitrary and borderline silly. JPMorgan, for example, provided daily cash flow statements for seven days after bankruptcy. But not eight! Evidently that eighth day was the kicker. Never mind that neither banks nor regulators can possibly know today how many days of liquidity the bank will need in a hypothetical future failure to prevent systemic disruptions while the FDIC winds it down-or what exactly cash flows will look like in that window. Particularly since bankrupt banks tend to be, you know, illiquid. A bankruptcy liquidity plan wouldn't at all have helped Lehman or Bear Stearns, because they had no cash and no market access. The derivatives wind-down stuff is also mind-boggling. Like, if BofA has to specify that it will dump its derivatives on Bank of Main Street USA, what do you think that does to Bank of Main Street USA? As for Goldman's allegedly flawed elevation process, if Rome is burning, we daresay Caesar knows. And, shocker, if Wells Fargo hasn't quite finished restructuring, of course its living will might not fully account for what is still a work in progress.

That all highlights a point: Of course banks' living wills aren't credible, because the process isn't credible. Banks can't possibly know now what environment they will face whenever the next crisis occurs. As a bank's hypothetical failure will occur in an imaginary environment amid wholly unknown conditions, the liquidity they need to avoid problems rippling elsewhere is unknowable. Banks also can't determine how willing other financial institutions will be to buy their assets in a panic. Counterparties may avoid anything related to the panic's perceived cause-even things that seemed safe previously. Pre-2008, banks may have assumed they could unload widely coveted mortgage-backed securities (MBS) in the event of peril. But the specifics of the crisis (namely, FAS 157, the mark-to-market accounting rule) caused an MBS fire sale, making them appear "toxic."

Regulators' shifting the sand makes formulating a credible plan even more problematic. In 2014 regulators suggested banks can't include borrowing from the Fed's discount window-a lending facility to help alleviate banks' short-term liquidity squeezes-as part of their living wills. If banks can't count on the lender of last resort to do what it was principally designed to do over 100 years ago, how can they properly plan to avoid the next crisis?

Also, it's unclear what would actually trigger a living will, which further calls into question how effective they may be in limiting a panic. Living wills theoretically kick in after the Fed and FDIC deem it necessary to put a bank into receivership. But clarity is lacking on what would actually trigger that decision. The Liquidity Coverage Ratio (LCR) is supposed to help banks cover a 30-day bank run, but using it as intended requires the bank to draw down its LCR below the minimum. Are they bankrupt once the LCR breaches the minimum, when it runs out, or something else? The Fed & FDIC's letters further confuse the issue, making it seem like living wills are supposed to help prevent banks from failing, which isn't the original intent. Regulators want to make sure banks have enough liquidity to avoid needing government money, but if they do are they really bankrupt? Knowing the answer to this helps banks develop good resolution plans in the first place. Without such clarity, they can't plan well, and this defeats the entire purpose of living wills. This lack of clarity is a negative for markets as well, as markets abhor uncertainty. While the messy aftermath of Lehman's demise may have contributed to volatility, this is more of a crisis footnote than a key driver. In our view, combined with FAS 157, the government's arbitrary determinations of who would be bailed out and who wouldn't were much more important. Regulators' arbitrary behavior isn't targeted by living wills, and the opaque and apparently ad hoc process only seems to codify it. "Keep 'em guessing!" isn't exactly a sensible credo for regulators.

Even if regulators provide clarity on this, and systemically important financial institutions present satisfactory living wills, the government may still decide to bail them out in the event of a crisis or panic. Maybe officials decide at the time a bailout is a better option than the resolution plan. If it seems like the entire financial system is on the brink (even if it isn't), politicians may think that justifies drastic action. Politicians may make such a decision based on politics, not financial circumstances (shocking, we know), which is why many Dodd-Frank provisions exist. Exhibit A: The Durbin Amendment. Exhibit B: The Fed's decision to force Lehman's bankruptcy and the subsequent panicky bailout of AIG, necessitated by its Lehman exposure. Regulators argue credible living wills would erase worries about counterparty risk, limiting the need for a bailout, but that's fantasy. For all the reasons above, markets would fairly quickly see through the documents' fecklessness and probably carry on panicking. Panics are, sort of obviously, not rational times. This is why they are called panics and not "the entirely orderly, measured unwinding of exposure to troubled institutions." The likelihood investors en masse pore over hypothetical plans drafted without the catalyst being known while markets are convulsing seems awfully low to us.

Given banks are very healthy these days, we are likely far away from the next crisis. However, if banks can't produce living wills regulators are comfortable with by October, they may be forced to raise capital, divest subsidiaries or otherwise limit growth. That regulators have been vague on how exactly they would sanction banks without credible living wills is itself another source of uncertainty banks and financial markets need to contend with. With just over five months to go, this is worth watching.

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