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Regulators, Demand Credible Living Wills Now — Not 'Ultimately'

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The speculation about what to expect in a second Obama term has overlooked one obvious possibility: another financial crisis.

According to JPMorgan Chase CEO Jamie Dimon, financial crises are "something that happens every five to seven years," which makes us due for the next one in the next four years. Tyler Cowen, a professor of economics at George Mason University, has said "the most important development to emerge from America's financial crisis" was that the "age of the bank run has returned," a view he ascribes to economists generally.

Rather than rely on insured deposits for financing, the biggest financial institutions now rely increasingly on the largely unregulated shadow banking system. The sheer size of shadow banking — $67 trillion, according to the Financial Stability Board — may create "a need for sudden payouts [that] could also prompt a run on a financial institution," Cowen says. "It now seems that the 21st century will resemble the 19th and early 20th centuries, with periodic panics and runs on financial institutions, perhaps followed by deflationary collapses."

All of this makes banking regulators' nonchalance about preparing for a crisis puzzling.

The Dodd-Frank Act did not break up the biggest banks into small-enough-to-fail institutions or end their reliance on shadow bank borrowing. Instead, the Act provides an "orderly resolution authority" so regulators can dismantle failing institutions without catastrophic consequences for the financial system or for the real economy.

The Act requires the largest institutions to submit resolution plans, or "living wills," to help regulators prepare. Living wills outline how institutions are organized and identify critical operations and known risks. Regulators use living wills to spot impediments to quick, orderly resolution in bankruptcy. If the plans do not show a credible way to avoid severe disruption, regulators can require tougher supervision or restructuring.

The biggest banks submitted their first living wills this summer. William Dudley, the president of the Federal Reserve Bank of New York, recently conceded that the banks' living wills "confirmed that we are a long way from the desired situation in which large complex firms could be allowed to go bankrupt without major disruptions to the financial system and large costs to society. Significant changes in structure and organization will ultimately be required for this to happen." The "initial exercise," Dudley said, provided regulators a "better understanding of the impediments to an orderly bankruptcy," and was the beginning of an "iterative process."

Simon Johnson, former chief economist for the International Monetary Fund, concluded from Dudley's remarks that the living wills process was "a sham, meaningless boilerplate and box checking." Maybe Johnson is too harsh, but "ultimately" is a very indulgent deadline in the new "age of the bank run." The uncertainties in the financial system may not allow for year after year of polite suggestions by regulators and modest tweaks by institutions.

Dudley said that the "current approach" of regulators is to reduce the likelihood that the biggest institutions might fail by requiring frequent stress tests, increased capital and liquidity buffers, and reforms to shadow banking and derivatives markets. "The bad news is that some of these efforts are just in their nascent stages," Dudley said.

The "blunter approach" of breaking up the biggest banks "may yet prove necessary," Dudley said, but it is "premature to give up on the current approach."

The "negative externalities" of the last crisis, to use Dudley's phrase, were widespread, long-term unemployment and underemployment; declining wages; the loss of decades of wealth accumulation by most families; and frightening rage that may be incompatible with enduring, stable democracy. A trial and error approach to regulation really should not be an option.

Megabanks have many incentives to remain too big to fail. They apparently enjoy immunity from criminal prosecution, even for "epic" rigging of the world's benchmark interest rates to defraud counterparties to interest rate derivatives, and for money laundering for terrorists, genocidal regimes and drug cartels. The "implicit government guarantee" provides almost unlimited liquidity for every line of business and allows megabanks to borrow more cheaply than smaller competitors. Megabanks will not voluntarily become small enough or simple enough to fail.

In fact, the most obvious impediments to orderly resolution appear intentional. The seven largest banks have 14,500 subsidiaries between them, but each megabank operates as a single enterprise with consolidated management and a common pool of capital and liquidity. As a result, every subsidiary is responsible for the liabilities of the parent corporation and all of the siblings. An obvious starting point for regulators is to require that the riskiest lines of business be conducted in separately managed, separately capitalized subsidiaries. A stand-alone subsidiary could fail without a collapse of the entire enterprise, and if the enterprise became insolvent, many subsidiaries could still operate relatively normally. Stand-alone subsidiaries would be easier to sell or spin off without serious disruption, even if the megabank is at the point of death.

The Dodd-Frank Act did not give regulators the choice of taking measures to make a panic less likely or planning for a panic. Banking regulators should act with urgency to require that living wills be credible plans to resolve failing firms without the "negative externalities" of the last crisis. Banking regulators should not wait for a protracted "iterative process" to remove obvious impediments to orderly resolution.

Rep. Brad Miller, D-N.C., is retiring after 10 years in the House. 

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Comments (2)
An organizational and capital restructuring plan for the orderly failure of a globally systemically important financial institution (G-SIFI) that is "too big to fail" is at a very early stage. However, Plans, known as living wills have yet to deal with these too-big-to-fail entities as a complex globe spanning information based technology system, part of an even more complex interconnected global financial system.

Optimism of living wills allowing subsidiaries to be kept operating, and businesses shrunk or broken into smaller entities, or certain operations liquidated or closed should be tempered with the reality of wading into a Rube Goldberg or Heath Robinson type complexity with no architects' plans on how these giant businesses were constructed in order to dismantle or transfer assets.

These giant financial conglomerations were built one acquisition atop another with many black box systems piled one atop the other in no particular order. That the blue print for these financial behemoths is missing is unquestioned. How then can regulators suggest they can be dismantled in some orderly way? We can't even describe the legal entities of these firms and their hierarchy of ownerships.

There are more productive ways of dealing with potential failures of too-big-to-fail orgnizations...reengineer them. After all, shouldn't we want to preserve the benefits of being big, global and diversified if society can manage their risk exposures and support their stabilizing effects on economic order?

We will surely pull the wrong brick or tug the wrong pipe and topple the whole edifice. Better to place a bet on slowly reengineering too-big-to-fail institutions rather than on their failure. Both contingencies are necessary, both would serve society's needs. Let the better plan win!
Posted by Allan Grody | Wednesday, December 26 2012 at 5:13PM ET
This is no surprise. The regime wants to control the banks completely. They know they can't actually nationalize the banks, but they will try to control the industry as if they had. This is merely one more step in their process.
Posted by Bob Newton | Wednesday, December 26 2012 at 8:05PM ET
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