Living Wills to the Rescue
A number of U.S. financial institutions remain so economically essential and so structurally complex that the government would have little choice but to rescue them in an emergency. A decision announced by regulators today represents an important step toward solving this "too-big-to-fail" problem.
Many economists and politicians remain concerned about the too-big-to-fail issue. Some, including presidential candidate Bernie Sanders, urge Congress to break up the banks. Perhaps I’m overly cynical, but I see little chance of any legislative movement on this front in the next five years.
That said, there’s potential for change to come from regulators. Today, the Federal Deposit Insurance Corp. and the Federal Reserve Board jointly declared that five major financial institutions (Bank of America, Bank of New York Mellon, JP Morgan Chase, State Street, and Wells Fargo) lacked credible plans to dismantle themselves in bankruptcy. Under the 2010 Dodd-Frank Act, that declaration gives regulators the power to force major changes at the banks -- including requiring them to sell assets.
To understand why this is so important, consider some context. During the crisis year of 2008, regulators had scant information on the structure or interconnections of the large financial institutions that ran into trouble. As a result, they had no way of knowing how to impose appropriate losses on the institutions’ creditors while ensuring that the financial system kept running smoothly. The disastrous bankruptcy of Lehman Brothers in September 2008 demonstrated how harmful such a failure could be.
The Dodd-Frank Act sought to address the problem by requiring systemically important financial institutions to formulate plans for their rapid but orderly resolution. These so-called “living wills” were intended to end the “too big to fail” problem. If regulators ever felt that a large financial institution was insolvent, they could use the living wills to ensure that the economy would be left unaffected by the imposition of appropriate losses on creditors.
If a systemically important financial institution was not able to come up with a credible living will, then the act empowered regulators to take more drastic measures. They could require the institution to finance itself with more loss absorbing equity capital, or ultimately to restructure -- a process that would likely involve shrinking.
It has proven very challenging for large financial institutions to actually come up with workable resolution plans. In August 2014, the FDIC found the living wills of 11 financial institutions (four of the five above and seven others) not credible. But without a similar finding by the Federal Reserve Board, the FDIC’s determination was not sufficient to trigger a regulatory response.
Today, more than 18 months later, the two regulators have agreed that the five institutions need to make large changes in their living wills by October 1, 2016. That’s the first important step in a process that may require those institutions to have a lot more capital or restructure.
It’s worth noting that a couple of the banks are actually not all that large in terms of assets or liabilities. The process focuses on the right measure: the potential systemic harm that a bank’s failure can cause. Just making a financial institution small may or may not be the correct remedy. Too-big-to-fail is not about size -- it’s about importance in a time of crisis.
I’m sure that the populist calls to break up the banks will persist. They speak to a deep desire among Americans for some kind of payback for the 2008 economic disaster. But those who are actually interested in ending too-big-to-fail should focus on the regulatory process around living wills. It’s working, slowly but surely, toward a desirable solution. And today is a real milestone in that journey.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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