Large banks are gearing up for a major test July 1 that could could reshape the U.S. banking system.
Eleven of the biggest U.S. banks and branches of foreign banks are required to submit “living wills” to regulators by July. The wills are plans that spell out in advance how exactly the companies would safely go through the bankruptcy process in a failure without the uncertainty and panic of the 2008 crisis.
The living wills were a provision of the 2010 Dodd-Frank financial reform law, intended to prevent a situation in which a bank’s size, complexity and connections with other firms make it impossible for the bank to shut down without threatening to bring down the entire system.
It’s a serious undertaking. Under the law, regulators at the Federal Reserve and Federal Deposit Insurance Corporation have broad power to ensure that the living wills are credible plans, including, ultimately, the authority to break up the banks — without Congress or the president doing anything.
The wills are submitted annually, but this year’s versions are particularly significant because regulators have said they won’t let banks skate by with poorly formulated plans. Expectations are high for them to come down hard on one or more banks.
“I think there’ll be a couple of heads on spikes,” said Karen Shaw Petrou, managing partner of the financial regulatory consulting group Federal Financial Analytics.
Federal Reserve Chairwoman Janet Yellen set the stakes during congressional testimony in February, indicating that her agency is ready to call out banks whose resolution plans are not up to the regulators’ satisfaction.
“If we don’t see the progress we expect, we’re fully prepared to declare the living wills to be not credible,” Yellen told senators.
Congressional proponents of breaking up big banks, such as Sen. Elizabeth Warren, D-Mass., and Rep. Michael Capuano, D-Mass., have pushed the Fed and FDIC to press the process as far as possible.
It would take a long time and a series of escalating confrontations for the living wills to prompt a bank break-up.
FDIC Chairman Martin Gruenberg described the sequence of events in an appearance before Congress in May. First: Regulators have to tell the bank if its plan is not credible. If the firm fails to fix the will’s shortcomings, the agencies may impose new requirements, such as higher capital or liquidity requirements, and limit the bank’s business or growth. After two years of the bank failing to correct the problems, regulators can force it to break up and divest its assets.
Even apart from that unlikely scenario, however, the living wills are already forcing banks to simplify their operations.
That was one of the demands made by the regulators in August, in a joint statement in which the FDIC, although not the Fed, said that the plans of all 11 banks were not credible. Both agencies asked the banks to simplify their legal structures.
Legal complexity is a major concern for the banks. Lehman Bros., for instance, had 3,000 legal entities before its failure in 2008, one of the contributing factors to the destabilization that followed its collapse.
It is difficult to assess just how much simplification has been done over the past year because of the confidentiality of the talks between regulators and the banks. Nevertheless, it’s been considerable, Petrou said.
“Several of the large banks…were just stunned when they essentially opened the lid to see just how complex they were,” Petrou said. “For their own reasons as well as for the living wills they’re simplifying their operational structure very considerably.”
Banks have been working hard to meet regulators’ requests. JPMorgan Chase, for example, disclosed in a letter to shareholders that it has more than 1,000 people working on living wills and resolutions, working over 1 million hours on it annually.
“We do share a common goal,” said an industry source, who asked not to be identified because of the sensitivity of the confidential process. “People are working their asses off to get these plans to a place that regulators and policymakers and the skeptics could say, ‘Oh yeah, this is a credible way they could be resolved through bankruptcy.'”
The compliance work is significant. “Bankers obviously are responsible for managing the risks in their organizations, but they spend most of their days running the business as a going concern, not dealing with it post-solvency,” said Hu Benton, vice president of Banking Policy for the American Bankers Association.
The banks are concerned about the living wills discussions being accelerated or overly influenced by congressional bank critics. That fear was raised last summer after Warren and others grilled Yellen on the living wills in congressional testimony.
“We take this process very seriously. We would be very concerned about this process if anyone were to handle it in any way casually, but we think now that people are being very careful and as thorough as possible in what they’re doing,” Benton said.
One issue that needs to be addressed by regulators, said Petrou, is how banks are expected to comply with a bankruptcy code that isn’t well suited for large banks, especially when it comes to sorting out their cross-border contracts.
But Federal Reserve Bank of Richmond President Jeffrey Lacker expressed optimism in May that the changes, while “unpopular,” could help end the problem of too-big-to-fail without destroying big banks. “I believe the changes that could result from living wills are feasible without sacrificing the inherent benefits large financial firms provide to the economy,” he said in a speech in Baton Rouge, La.
The regulators are expected to respond to the living will submissions by the late summer or fall.
