It's the Liquidity, Stupid: Regulators to Big Banks

WASHINGTON — Regulators cited a slew of technical concerns in their response to megabanks' living wills, but the technological, logistical and legal flaws they found appeared to center on a single issue: liquidity.

The Federal Reserve Board and Federal Deposit Insurance Corp. were clearly concerned whether global banks can stock up on enough cash and highly liquid assets to subsist during bankruptcy, experts said.

"Liquidity as a whole is a critical piece of the puzzle," said John Simonson, a principal at PwC. "The regulators want to make sure that the plans are very detailed, in order to make sure that there in fact is the right amount of liquidity in the right legal entities at the right time."

The FDIC and Fed expressed their concerns about liquidity both directly and indirectly. They asked, for instance, if the firms' mechanisms for failure — who pulls which levers and when — were thorough enough. In the next round, the megabanks will be expected to explain why they would agree to undergo bankruptcy while still holding a substantial amount of cash reserves.

"Will the board actually pull the pin?" asked Joseph Fellerman, a former top adviser at the FDIC's Office of Complex Financial Institutions. The repercussions of such a decision would be immense both to the organization and individuals making the final call. "Effectively they're talking about putting themselves out of a job, and then subjecting themselves to litigations post-failure," Fellerman said.

The agencies also highlighted flaws in the information technology systems of banks, raising concerns about whether they could be relied on to track collateral and other essential funding data in a timely manner.

These capabilities are a requirement if banks are to apply for financing during a bankruptcy, said James Wigand, a partner at Millstein & Co. who served as first director of the FDIC's OCFI. Otherwise, "Your system does not provide you with the ability to determine which assets you have available to pledge in real time."

Regulators also called upon banks to more accurately calculate and address ring-fencing, or the risk that a foreign authority would trap capital or liquidity in that jurisdiction, and to better account for the continuation of shared services across different entities during the wind-down process.

Overall, the FDIC and Fed want a full picture of how the different firms are meant to keep running throughout the process of an orderly bankruptcy — and sufficient cash on hand would oil the wheels.

Living wills should address "not only going into bankruptcy, or the leading up to bankruptcy or the immediate aftermath of bankruptcy," Fellerman said. They must cover "the A to Z of a bankruptcy," including exit strategies.

The focus on liquidity is part of a sea change in how the agencies are approaching the living wills process.

"What the regulators are asking for really is a paradigm shift," said a source with knowledge of the process. "Being able to just operate as a going concern is no longer adequate. The institutions are being asked to be able to have a structure that allows for resolution."

But if banks are expected to be constantly prepared for a bankruptcy, experts say, liquidity is a more intractable problem than regulators have made it out to be.

The living wills, enacted under the Dodd-Frank Act's Title I, are supposed to show how banks can be put through the bankruptcy process without government assistance, which is allowed under the law's Title II. But many said that's an unrealistic expectation because banks simply aren't likely to set aside enough cash for that.

Instead, they say the living will process will allow regulators to make changes now to enable the agencies to be able to take the banks apart in the event of a crisis, using the FDIC's "orderly liquidation authority."

That's why Kathryn Judge, a professor at Columbia Law School, views the resolution planning process not as an end in itself, but as a lifeline.

"Title II is more likely to be used by a significant margin than bankruptcy, unless there's a significant rewrite of the bankruptcy code," she said. "Having a Title I plan that is at least somewhat viable could be a critical backstop."

FDIC Chairman Martin Gruenberg has regularly called OLA the "backstop" to the Title I bankruptcy provisions, but some have interpreted his statements differently.

Barely a week after regulators announced that a majority of U.S. systematically important banks had failed their living wills plans, Gruenberg said he believed that too-big-to-fail was over.

"In my view," he said in Amsterdam on April 21, "we are at a point today that if a systemically important financial institution in the United States were to experience severe distress, it would be resolved in an orderly way under either bankruptcy or the public orderly liquidation authority."

That might be an indication that regulators and banks alike consider OLA to be the most viable option, even though they are statutorily obliged to go through the living wills process.

It's unrealistic to ask complex global banks to fund their own bankruptcy, said Fellerman. For one, a bank would need a considerable amount of money to keep its core subsidiaries running throughout without panicking the economy.

"There's a cognitive dissonance in the way firms can approach the liquidity issue," Fellerman said. "Financial firms can't stop paying bills. They can't delay paying bills; that's when loss of trust starts playing a role and that's when liquidity starts going out the door rapidly."

And if the institution does have enough cash, it is unlikely to consider itself troubled.

"Can you really enter bankruptcy with $150 billion if you're a bank? Are you really in danger of failing?" Fellerman said.

Even as the agencies delved into the issue at length in their guidance to banks, they seem to have left it up to the banks to determine exactly how much liquidity they should hold.

Regulators may have decided to avoid explicit requirements to give themselves "wiggle room," Judge said.

"The focus" in the publicly available feedback "is very much on the processes and procedures in place," she said. "They've intentionally avoided signaling, 'Well if you get that much liquidity you're going to be OK.' "

That might be in part because regulators intend the resolution planning process to be more than just a compliance exercise.

"The living will structure is very much meant to put the burden and the onus on the banks to provide the road map the regulators would then implement," Judge said.

From the regulators' perspective, the end formula should be different for each bank.

"The answer to how much liquidity is needed is quite idiosyncratic and it's really driven by the individual firm's organization, its business practices, its funding structure and its resolution strategy," said Robert Burns, a managing director at Chain Bridge Partners and a former FDIC deputy director. "It's a very bespoke number."

Ultimately, the guidance in advance of large banks' next living wills due in July 2017 might effectively raise the bar on firms' liquidity reserves, but that would depend on a firm's broader restructuring strategy for bankruptcy readiness.

"The solution could be holding more liquidity," Burns said. "The solution could be 'change your business practices or funding model.' "

But liquidity is the fulcrum for Dodd-Frank critics who say that bankruptcy planning for large banks could have unanticipated effects on the economy.

"It's going to require the firms to have much more intense internal debate over where the future of their firms should be," Fellerman said.

If the megabanks determine they should hold onto more money as a result, barriers to credit might rise.

"Liquidity is costly for banks," Judge said, "but it's also socially costly to ask banks to hold too much liquidity."