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18. Living Wills

Published onApr 08, 2020
18. Living Wills

Delay in resolution means more time for short-term creditors to run, and loss of franchise value. Following the financial crisis of 2007 to 2009, many believe these risks are acute for large, complex, or otherwise systemically important nonbank financial institutions as well as banks (including bank holding companies). Living wills1 are intended to make resolution faster. But a faster procedure cannot assure short-term creditors of an unimpaired recovery of their investments, so they will not deter those creditors from withdrawing as soon as a struggling financial institution appears to be in danger of failing. Furthermore the very idea of planning the disposition of complicated corporate estates is dubious. In my view, living wills should focus on a key systemic risk posed by the failure of a few financial institutions—the potential loss of the provision of critical functions like clearing and settlement.

There is no doubt that resolution of large financial institutions pose great difficulty because of their complexity. Figures compiled by Kaufman (2010) show that Lehman Brothers Holdings incorporated nine banks, three insurance companies, 84 mutual and pension funds, 210 other financial subsidiaries, and 127 “nonfinancial” subsidiaries—in all, 433 subsidiaries in 20 countries—less than a year before its collapse. These numbers pale beside Citigroup, which encompassed 101 banks, 35 insurance companies, 706 mutual and pension funds, and over 1,500 other financial and nonfinancial subsidiaries at year end 2007. Statistics for other “large complex financial institutions” (LCFIs) such as Bank of America, JPMorgan Chase, and Deutsche Bank paint a similar portrait of geometric organizational complexity at the larger end of the financial services industry. Living wills are possibly one way to cope with these costs by requiring managers to maintain “inventor[ies of] … all assets and liabilities,” catalog derivatives counterparties, formulate a plan to maintain core operations and customer services during a workout, and take steps in advance to address complications related to the cross-border nature of contemporary banking. Living wills are in effect a way for managers and regulators to rehearse for resolution by choreographing the steps they would need to take when the time comes.

But it is far from clear that living wills will actually speed up resolution or what the systemic risk concern (as opposed to franchise value concern) is with not speedily disposing of thousands of relatively unimportant subsidiaries. Furthermore, if a living will is to serve as more than just an itemized list of assets and liabilities, it must make a complicated set of assumptions about the shape of the future financial crises in which it might be tested. Plans that are too specific will be ineffective in a wide range of possible alternative scenarios; those that are too broad in their design will require regulators to fill in most of the detail in the midst of a crisis, negating the public cost-savings that they promise in principle.

Living wills, it is hoped, may also encourage leaders of financial firms to simplify their organizational structures. Former FDIC chairman Sheila Bair stated “the FDIC and the Fed must be willing to insist on organizational changes that better align business lines and legal entities well before a crisis occurs.” Bair contends that this structural simplification will allow management—as well as regulators—to better understand and monitor risks and interrelationships between business lines. Andrew Kuritzkes, who has argued in favor of a tax of $1 million per subsidiary on large financial institutions, sees additional benefits to structural simplification. Encouraging structural simplicity would combat large-firm externalities created by cross-border activity, legal complexity, and regulatory forum shopping.

Title 1, §165(d) of Dodd–Frank requires all SIFIs to develop advance resolution plans to be reviewed and approved by regulators. Specifically, the Act requires the Federal Reserve Board to require all supervised nonbank financial institutions and BHCs with greater than $50 billion in assets to make regular reports to the Federal Reserve, FSOC, and the FDIC on their advance planning for orderly resolution under the Bankruptcy Code. The FDIC and Federal Reserve approved a joint rule implementing the §165(d) requirements in September and October of 2011, respectively, and the rule became effective on November 30, 2011 (the “DFA Rule”).2 In January, 2012, the FDIC approved a complementary living will rule known as the Insured Depository Institution Rule (or “IDI Rule”).3 The IDI Rule requires insured depository institutions with $50 billion or more in assets to submit resolution plans to the FDIC under the Federal Deposit Insurance Act, with the FDIC as receiver.4

The Federal Reserve and the FDIC review plans submitted by covered institutions for credibility. Institutions that fail to submit living wills for review or that submit deficient plans may be subject to higher capital and liquidity requirements as well as more severe activity restrictions. Indeed Dodd–Frank empowers the Federal Reserve and the FDIC, in consultation with FSOC, to require institutions to divest “assets or operations” that would interfere with an orderly resolution. Under the DFA Rule, the Federal Reserve and the FDIC may direct an institution to divest assets and operations if it fails to submit an acceptable revised plan within two years of obtaining notice of the plan’s deficiency.5 The IDI Rule does not expressly provide for noncompliance sanctions.

Thomas Hoenig, Vice Chairman of the FDIC, has commented that the living will requirements are leading some firms to reduce their size.6 Regarding the regulations’ impact on organizational structure, he has remarked, “We’re not going to break you up, but we want you to structure yourself so that your failure doesn’t bring the economy down next time. If you can’t get to that point with your current organization structure, then you should sell assets to get to that state.”7 However, the failure of an institution of any size can spark a contagious panic—the response to the failure of Lehman Brothers, which was less than half of the size of the largest banks, is a prominent example of this phenomenon. A “breakup” of big banks in any form is therefore unlikely to represent a meaningful check on the threat of contagion.

In August 2014, the Federal Reserve and the FDIC informed all eleven of the largest US banks of their failure to meet Dodd–Frank’s living will standards.8 The Federal Reserve and FDIC listed a number of reasons for the inadequacy of the living wills. First, the regulators indicated that the living wills did not put forth a credible bankruptcy plan; yet, the regulators were not clear what a living will must include in order to be deemed credible. Regulators further asserted that the banks did not articulate how different counterparties would respond in the event of a bank’s downturn. However, it is essentially impossible to predict how counterparties would respond in the event of distress at a critically large banking institution. Finally, the regulators criticized the banks for failing to explain how cross-border jurisdictional issues would be resolved in the event of a bank’s demise and for identifying the Federal Reserve as the lender of last resort in the context of living wills. However, it remains difficult for banks to determine how to resolve cross-border jurisdictional issues when US regulators have not yet come to a binding agreement with international counterparts. It is similarly difficult for banks to not acknowledge the key role the Federal Reserve would play in any large-scale banking crisis. In July 2015 the banks refiled their living wills, and they expect to receive feedback from the Federal Reserve and FDIC by the end of 2015.9

One very important issue that living wills should address is how critical functions performed by financial institutions, such as clearing of tri-party repos, custody or perhaps even asset valuation, can continue to be performed if a financial institution fails. This may require plans to isolate this activity from the rest of the institution or to transfer it seamlessly and quickly to another institution. If the function requires funding, plans should exist as to how that funding can be practically obtained from the private sector, and if need be the public sector. Without the assurance that critical functions can continue to be performed in the case of insolvency, financial institutions may be too critical to fail. Preservation of critical functions should be at the top of the priority list for living wills planning.

Living wills may help resolve complex banking institutions but they cannot stop short-term creditors from running on financial institutions that are in or might be in resolution—they are just another perhaps useful procedure to enable resolution.

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