WASHINGTON – The financial world is anxiously awaiting regulators' verdict on the latest round of resolution plans for the 12 largest and most complex banks, a test that will determine the credibility of the so-called living wills and whether "too big to fail" is really over.

While little is known about what regulators are grappling with, experts deeply familiar with the agencies' process are speculating that one issue could be a determining factor in whether the plans are deemed credible or sent back to the drawing board: liquidity.

"The largest, most complex institutions that have operations in multiple jurisdictions and multiple business lines will have the greatest challenge in addressing liquidity during the resolution process," said James Wigand, a partner at Millstein & Co. who served as the Federal Deposit Insurance Corp.'s first director of the Office of Complex Financial Institutions.

In interviews, several former regulators said that many of the obstacles that financial institutions share in addressing their living wills – including structural complexity, shared services, cross-border operations and ringfencing – are themselves closely tied to liquidity.

Large banks "have a funding and liquidity issue that needs to be addressed," said Robert Burns, a director at Deloitte and former deputy director at the FDIC complex-institutions office. "[T]here's a lot more attention on it now."

Regulators have already tried to address liquidity requirements to ensure a bank can withstand financial stress. The Federal Reserve Board finalized a rule that establishes a liquidity coverage ratio to ensure big banks have enough high-quality liquid assets to withstand a 30-day crisis. The central bank is also working on another liquidity requirement that would address longer-term liquidity needs.

But both those rules are only designed to address how to keep an institution alive in a time of crisis. In the context of living wills, the liquidity issue is somewhat different. The resolution plans are premised on the idea that the firms will not receive government assistance. As a result, regulators have to evaluate whether firms have enough liquidity on hand not to avoid failure but to keep important functions operating while the firm is going through the bankruptcy process.

Institutions must first determine how they would calculate "the amount of liquidity necessary to ensure continuity of critical operations and maintenance of market confidence during the resolution process," Wigand said. But they also have to locate "a source of liquidity … that appears reasonable" during a resolution process.

That may prove impossible, however. For one, regulators may have even inadvertently set up a Catch-22. If a bank has enough liquidity to go through bankruptcy without government help, it arguably has enough not to fail in the first place.

"If living wills are to rely on bankruptcy, liquidity is the fatal issue that needs to be solved," said Joseph Fellerman, who retired in December as a top adviser at the FDIC's complex-institutions office. "Would a board of directors really bankrupt one of these large [banks] with $200 billion still on the books? I think that would be a far-fetched scenario."

Experts also warn that a failing firm is likely to burn through most of its required liquidity well before it reaches the resolution stage.

"Markets will deprive a large financial company of liquidity before regulators determine that the company has depleted its capital," Wigand said. It is "extremely difficult during times of market instability to determine asset values."

But others argue that such fears are overblown. They say changes that banks have already made go a long way toward creating a viable revenue system that could help the institution keep the lights on as it works its way through the bankruptcy process.

"I understand [the] skepticism," said John Simonson, a partner at PricewaterhouseCoopers and former deputy director at the FDIC's complex-institutions office. "Because historically financial firms didn't … go into resolutions until basically they ran out of money."

But, he added, the living-will process "has created a new approach, a new framework for the resolutions of these large firms."

Among the 12 largest and most complex banks that filed their most recent resolution plans in July, some ought to be better equipped than others to identify sources of liquidity and plan their distribution throughout the bankruptcy process, observers said. Generally speaking, those with a simpler structure will have an easier time.

"Institutions that have fewer business lines and fewer jurisdictions of operation should be able to address it more readily," Wigand said.

Liquidity has been front and center of the living-wills process from the beginning as regulators identified it as one of five central obstacles in joint guidance issued before banks submitted their 2013 living wills.

Banks have also changed how they approach the issue since the process got underway in 2012.

At first, many of the firms were exploring multiple-point-of-entry strategies, which would result in the parallel failures of a holding company and the firm's subsidiaries. Such a setup made it more likely that a firm would run out of liquidity faster, potentially meaning that the FDIC would have to use part of the Deposit Insurance Fund to pay off a potential creditor debt.

According to Wigand, who had access to the 2012 bank plans as an FDIC official, "the manner in which liquidity had been addressed had a lot of room for improvement."

More recently, however, most of the 12 banks have moved toward a single-point-of-entry strategy, which allows banks and other subsidiaries to keep operating while a holding company is unwound.

In that strategy, "the parents would in fact apply for bankruptcy when the operating subsidiaries have sufficient liquidity," Simonson said.

Such a strategy mimics the same tactic the FDIC would likely use to seize and unwind a failing behemoth, effectively paving the way for the largest banks to ease into a taxpayer-assisted failure.

But such plans bring their own share of obstacles – both financial and operational. Firms that choose this strategy have proposed to resolve them with trigger mechanisms.

"The firms need to be able to show that that liquidity can be placed where it's needed most," Simonson said. "That's why having the right governance and the right trigger framework around this issue is such a critical component."

But Fellerman remains skeptical such a setup can work. Financial institutions dealing with tighter oversight since the financial crisis – including higher capital requirements – will have less financial leeway today to implement such processes.

"We're actually in a position where you might fail and have to declare bankruptcy because of a lack of liquidity," Fellerman said.

Fellerman added that access to liquidity lies at the heart of how regulators would coordinate a failure across borders.

"Can Britain provide liquidity to the U.S. operations of HSBC, Barclays if those firms fail?" he asked. "For the moment, we're playing the game of, 'We'll believe you, today.' "

At its core, the question of liquidity also draws on assumptions by regulators as to how they should evaluate a bank's resolution plan – in a vacuum, adjusting for widespread economic turmoil, or somewhere in between.

"Looking at a living will and assessing its credibility for idiosyncratic failure of a company during a relatively overall healthy financial environment is a different situation than if the company were to fail and others were failing as well," Wigand said.

That's a crucial question that's still unclear, experts said.

"How individualized will the reviews and determinations be, and are the regulators grading on a curve?" said Bimal Patel, a financial services lawyer at O'Melveny & Myers and former FDIC adviser. "There is evidence that the process seemingly has become more individualized."

Some critics of Dodd-Frank view the entire living-will process as deeply flawed. Republicans in Congress have called for the creation of a specialized bankruptcy process tailored to large financial institutions.

Fellerman said that Title I of Dodd-Frank won't "ever work until the Bankruptcy Code changes."

Part of their issue is that the financial reform law actually creates two separate ways to handle a failing banking company. Title I, which is the part of the law that requires living wills, assumes no government assistance. But Title II proceeds to outline how the government could step in for help. Regulators essentially have to pretend that Title II doesn't exist when they evaluate banks' living wills.

"[Liquidity] is a problem under a Title I proceeding, and that's yet another defect of the bankruptcy laws," Richard Herring, a professor at the University of Pennsylvania's Wharton School, said during a February panel organized by the U.S. Office of Financial Research and the Financial Stability Oversight Council.

Herring added that a likely scenario would entail a procedure to "determine that it would be a risk to the financial stability [to] proceed with a bankruptcy," which would allow regulators to carry on with a Title II resolution.

"But nobody is going to say that," Herring added, "because that's against the law. ... They're supposed to all be resolvable under Title I."

In the end, the question may turn on how much exposure regulators are willing to allow banks, and how that plays into their ability to withstand a failure without any form of public assistance.

"What does our optimal enterprise look like?" Fellerman asked. "What are we hoping to get out of this entire process? I don't know what the Fed's answer to that is, and I don't know what the FDIC's answer to that is."

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