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Banks and Regulators Converging on Living Wills

By Aaron Klein, Kristofer Readling, Justin Schardin

Thursday, January 21, 2016

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Banks and regulators appear to be more aligned in their views on how to prepare for any financial distress. A review by the Bipartisan Policy Center’s Financial Regulatory Reform Initiative (FRRI) of so-called “living wills” required of large financial institutions in the aftermath of the financial crisis found encouraging signs that banks and regulators are getting onto the same page.

Banks with $50 billion or more in assets are required to develop resolution plans, often referred to as “living wills.” Living wills are designed to facilitate a rapid and orderly resolution of these banks at a time of financial distress. The public portion of a living will provides a high-level overview of the strategy a bank would pursue during a traumatic financial event and is devoid of confidential information. Living wills were created and required as part of the post-recession reform of financial regulation in Dodd-Frank.

In 2012, the largest banks submitted their first plans to the FDIC and the Federal Reserve Board (Fed), the two regulators required to review them under the law. Upon review, the regulators stated that the plans made “assumptions that the agencies regard as unrealistic or inadequately supported” and failed to consider the structural changes necessary for orderly resolution. Since then, the banks have submitted updated living wills annually as required by Dodd-Frank. The banks’ most recent plans are currently under review by the FDIC and the Fed with an expectation that the regulators will pronounce judgment soon.

We reviewed the publicly released portions of the living wills of some of the largest banks each year from 2012 to 2015 to see how they evolved.1 In 2014, FRRI suggested that regulators could improve living wills, stating that the FDIC and Fed should be “converging the living will and single-point-of-entry processes.” We wanted to see if things had changed.

We were encouraged by what we found. Here’s why:

High Level Trends

Use of Single Point of Entry

The initial round of plans provided for a number of resolution strategies including FDIC receivership, Chapter 11 bankruptcy, purchase by a competitor, and resolution by the Securities Investor Protection Corporation, among others. These 2012 plans were submitted before an important FDIC and Bank of England announcement of a new strategy for failure resolution of large, complex financial firms called single point of entry (SPOE) in December 2012. SPOE allows a single regulator to resolve a large, complex and even globally active financial institution by taking the group holding company into receivership and using holding company assets to recapitalize material subsidiaries. After recapitalization, the holding company is placed into bankruptcy, using Chapter 11 of the Bankruptcy Code to be resolved. At the same time, the operating subsidiaries of the holding company would continue normal operations, thus reducing disruptions of service to customers.

After the FDIC and the Bank of England published the SPOE white paper, other international regulators showed support for the SPOE strategy, including the Swiss Financial Market Supervisory Authority and the German Federal Financial Supervisory Authority. FRRI strongly supported the SPOE strategy, stating that living wills “should succeed in solving a critical part of the too-big-to-fail problem, by allowing any [systemically important financial institution] to fail without resorting to taxpayer-funded bailouts or a collapse of the financial system.”

Banks have now embraced SPOE as well. In the 2015 plan submissions, virtually all of the 11 institutions we reviewed shifted their strategy to SPOE. The few that didn’t had less diversified holding company structures with most of their assets concentrated in a subsidiary bank so that standard pre-Dodd-Frank FDIC receivership was still sufficient. The broad use of SPOE in the living wills is important because it indicates that the regulators and regulated are on the same page.

Increase in Detail

Another major change between the first wave of plans in 2012 and the most recent was the level of detail provided in the public portions. On average, the 2015 plans were twice as long and addressed specific qualitative factors not referenced in the first wave. One of the common factors addressed was legal complexity measured by the total number of legal entities within a holding company. Many of the plans we reviewed showed that large institutions are combining and dissolving a large number of their subsidiaries. The number of subsidiaries and unclear connections between them was often cited as one of the major problems in the resolution of Lehman Brothers. One of the goals behind living wills was to both identify and streamline these legal entities and that appears to be occurring. Reducing these entities, where feasible, should make failure resolution simpler and more effective under most conditions.

This week, in a joint event, BPC and the Hoover Institution will explore another approach to the too-big-to-fail problem; amending the Bankruptcy Code to add a special subchapter for large, complex financial institutions. Living wills would improve the effectiveness of bankruptcy by mapping out the resolution of the firm thus limiting the efforts and expense of the bankruptcy courts.

1 The eleven banks reviewed were Goldman Sachs, JP Morgan Chase, Citi Group, Bank of America, Wells Fargo, Morgan Stanley, BNY Mellon, Credit Suisse, UBS, Barclays, and Deutsche Bank.