Why Banks Should Take Living Wills Seriously

Hard to resolve.

Photographer: Christopher Dilts/Bloomberg

U.S. banks are safer today than they were in 2007, but not yet as safe as they should be. For the second time in two years, regulators have found that some of the country's biggest banks can't adequately explain how they could go under -- should it come to that -- in an orderly fashion, at no cost to taxpayers, and without destabilizing the wider financial system.

The Dodd-Frank Act of 2010 told large financial institutions to draw up "living wills" -- plans for dismantling the enterprises if they go bust. This was seen as an extra safeguard, beyond requiring banks to pass stress tests and finance their lending with adequate capital. Stress tests can't cover every possibility, the thinking went, and even a well-capitalized bank can fail. If that were to happen, its bankruptcy ought to cause as little damage as possible.

Banks have struggled to comply. In 2014, the Federal Reserve and Federal Deposit Insurance Corp. sent the living wills back for more work. The regulators announced their judgment of that work this week. While noting some improvement, they found faults in all of the revised plans that eight systemically important U.S. banks filed in mid-2015. (Citigroup's plan, despite "shortcomings," was provisionally approved.) Five of the wills were deemed "not credible," which allows the regulators to impose changes -- including requiring more capital and even forcibly shrinking the banks -- if the deficiencies are not made good.

In judging these plans, one issue is whether banks have sufficient cash and other liquid assets to keep their businesses running while they are wound down or sold. Some experts believe that the needed liquidity could amount to hundreds of billions of dollars, as short-term creditors demand their money back and derivatives counterparties seek more collateral. Another question, even harder to judge, is whether the banks have staffed and organized themselves in such a way that this process would be well-managed, rather than causing panic.

Case by case, it's hard for investors to assess the plans, because only a small portion is made public. For the same reason, it's hard to know whether the regulators are being too demanding, as some banks argue, or not demanding enough. A valid complaint about Dodd-Frank is that it overcomplicated the regulatory system -- and one of the main reasons for demanding adequate capital is that other parts of the system could then be made simpler and less onerous.

Nonetheless, extra capital doesn't guarantee a bank against failure, and regulators need to consider what might happen in the worst and possibly unforeseen case. Ambitious, enterprising bankers want to concentrate on growing their businesses. They'd prefer not to think about winding them down. Bearing in mind the harm that a failing big bank can cause, regulators are right to insist.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.