Anxiety Over Living Will Grades Goes Beyond Banks

As Federal Reserve Board Chair Janet Yellen recently told the Senate Banking Committee, the regulators' grades on the latest round of the "living wills" for the nation's 11 most systemically dangerous banks will be released shortly. It's not clear who should be the most nervous: the banks, the regulators or the American people.

The banks should be nervous because they spectacularly flunked the last round of living wills for which they received grades. The Fed and the Federal Deposit Insurance Corp. effectively found that the 11 banks had failed to demonstrate that they could be resolved under the Bankruptcy Code without requiring taxpayer bailouts. This shouldn't really surprise anyone, since the too-big-to-fail banks want taxpayers to backstop their activities and bail them out if necessary. If their living wills are again subpar, the Fed and the FDIC will likely order the banks to take steps to become more resolvable. Under the Dodd-Frank Act, the regulators can ultimately require institutions with shoddy living wills to dispose of or spin off business lines or activities so that they can be resolved in bankruptcy. In other words, the regulators will order them to break themselves up.

The regulators should be nervous because their credibility is on the line: After they failed the entire class it should not be surprising if an outbreak of passing grades is greeted with skepticism, especially when the regulators keep the tests and almost all details of the grading process secret.

And perhaps the American people should be most nervous of all. It is their money on the line if they end up bailing these banks out again or they suffer the consequences when these banks fail catastrophically. When the nation's largest banks nearly collapsed in 2008, the ensuing crisis and recession cost the U.S. economy more than $20 trillion.

In truth all three groups — the banks, the regulators and the American people — should be on edge. A lot is at stake here. And no matter what the regulators decide, there will likely be plenty of skeptics unsatisfied by the outcome because the process by which the regulators are reviewing and grading living wills has been flawed.

Although the banks have released public summaries of their living wills, these summaries are a small fraction of the thousands of pages they have submitted confidentially to the regulators. And the regulators have evaluated these private submissions without any public scrutiny or accountability whatsoever. As former FDIC head Sheila Bair put it, the rest of us — those of us who will be called upon to bail out the banks if the regulators get it wrong — have to "take it on faith" that the regulators are doing their jobs and getting it all right.

The irony, of course, is that the regulators could have done a lot more to get buy-in from the stakeholders in this process. Better Markets recently released a policy brief explaining several ways in which the regulators could improve the "living wills" process so that all of the parties could be sure that the process was both fair and effective.

For example, the regulators should have been more transparent about how they were reviewing and grading these living wills. They could have required much more of the living wills to be made public so that outside experts — bankruptcy lawyers and finance professionals — could have independently evaluated whether the resolution plans were credible. Making these living wills public also would have provided the creditors and counterparties with valuable information they needed to price for risk, which would greatly strengthen market discipline. And those prices would perhaps have been the clearest signal on whether the plans are credible or not. Nothing inspires clear thinking like having money on the line.

Such a transparent process could have reassured us all that the living wills were in fact credible. For example, one of the biggest impediments to resolving a financial institution with a trillion-dollar balance sheet under the Bankruptcy Code seems to be obtaining the funding to reorganize such an institution while in bankruptcy. Before the financial crisis, the largest debtor-in-possession funding facility that was put together by a consortium of private lenders was $11 billion. During the financial crisis, General Motors drew upon a $34 billion facility, which came from the U.S. Treasury. Some scholars have estimated that the funding facilities that will be necessary to wind down a bank with a trillion-dollar balance sheet could be in the hundreds of billions of dollars.

If the regulators really want us to believe that these livings wills and the review process are credible, they should require these institutions to also publicly disclose how much funding they think it would take for these institutions to be resolved in bankruptcy, and where they think that money is going to come from. This information would establish whether or not taxpayers are on the hook.

These changes are too late for this round of the "living wills" process. But these steps to reform the process can help make sure that the next round really does result in living wills that do exactly what they are supposed to: ensure that the biggest banks can be resolved in bankruptcy without having to be bailed out again by taxpayers.

Dennis Kelleher is the president and CEO of Better Markets. Frank Medina is the senior counsel and director of research of Better Markets. Follow them on Twitter @BetterMarkets.