By HAL S. SCOTT
Originally published by the Wall Street Journal on September 4, 2014
Most college students now returning to campuses will never hear the words that the Federal Reserve and the Federal Deposit Insurance Corp. spoke in August to the managements of the country’s 11 largest banks: You’ve failed.
Each of these big banks flunked the course titled “living wills.” The Fed and the FDIC required the banks to make contingency plans detailing how in a crisis they would be wound down without suspending critical financial services, and without public support. The two regulators announced jointly last month that no plan earned a passing grade.
It is highly unlikely that an entire class of college students would fail a course, in part because a syllabus lays out the requirements for a passing mark. Not so for banks constructing living wills. Reports on the dialogue between regulators and the big banks show that the Fed and FDIC set objectives but offered no clear guidance on how the banks could meet them.
The FDIC said in an Aug. 5 statement that the plans provided “no credible or clear path through bankruptcy.” Such pronouncements open up the possibility of potentially harmful regulation, including hiking capital and liquidity requirements further, and even asserting broad power to break up the biggest banks. Should any such measures be necessary to preserve critical bank functions, then a well-defined process for evaluating living wills must make that clear.
There is no such process, and no one can answer what it will take to devise a living will that will pass muster with the Fed and the FDIC.
Regulators have faulted living wills for not adequately predicting how counterparties—derivatives customers, clearinghouses and hedge fund clients, for example—would respond to a bank nearing insolvency. This criticism borders on the preposterous. It is difficult enough to plan for one’s own death. It is impossible for any bank, let alone all banks and their regulators, to determine how others would react to it. In 2008 some banks that weren’t directly exposed to the Lehman Brothers failure nonetheless experienced runs that threatened their solvency.
Regulators have also criticized living wills for not including expectations of how regulators from different jurisdictions would work together during the insolvency of a global bank with assets in several countries. But foreign and U.S. regulators do not have any binding agreements regarding the resolution of a failed large bank that operates across borders. If the regulators cannot say how they would cooperate, how can they require the banks to do so?
Banks also were surprised to learn that regulators would not permit their living wills to rely on the Fed as a lender of last resort. While regulators are correct to rule out central-bank loans to insolvent institutions, the Fed has long been the lender of last resort to solvent institutions with liquidity problems. Banks cannot reasonably be expected to disregard the role the Fed has typically played in crises.
Regulators should ensure that functions critical to the financial system continue if a large bank becomes insolvent. There are ways to determine which services are most important, and the Financial Stability Board has already outlined some, including clearing and settlement activities for various asset classes, asset-class valuations, custodial services and participation in wholesale lending markets. Large banks that do not perform any of these functions don’t need a living will. For those that do, the living will needs to convince regulators that the bank subsidiaries housing these critical functions are protected from cross-guarantees with other subsidiaries and from exposure to lack of funding by short-term creditors.
Regulators could also require banks to have contingency plans that allow other institutions to take over their critical services if they become unable to perform them. Banks should not, however, be asked to specify in the living will how the thousands of their subsidiaries not critical to the financial system would be handled.
Until regulators clearly define the criteria for a living-will passing grade and focus on their mission of sorting out critical from noncritical functions, bank by bank, they risk undermining the process and their own credibility.
But if regulators assure the market that any of a large bank’s critical functions will remain operational when a bank becomes insolvent—while assuring taxpayers that no public support will be necessary—and if we also equip regulators with tools to combat contagious runs, then no bank will need to be “too big to fail.” The resolution process will have earned not only a passing grade, but high honors.
Mr. Scott is professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation.