Why the 'Living Will' Process Sets Banks Up for Failure

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Last Tuesday, the Federal Reserve and the Federal Deposit Insurance Corp. rejected the living wills of 11 of the biggest bank holding companies in the U.S. This gives regulators inordinate control to restructure the companies as they see fit.

The Dodd-Frank Act requires large financial institutions deemed systemically important to submit an orderly resolution plan each year. These plans — called "living wills" — run thousands of pages. They describe the company and its risk exposures, as well as the company's strategy for reorganizing itself in bankruptcy without causing financial instability or using taxpayer dollars. If banks fail to persuade regulators that they have a realistic and safe plan for winding down, the government can use Dodd-Frank's Orderly Resolution Authority to resolve them outside the court system if they get into trouble. In other words, banks have enormous incentive to make sure their living wills are convincing.

But the power of the living wills lies beyond what's written down on paper. Living wills are a gateway for regulators to change the company itself. If companies' living wills are not to regulators' liking, regulators can require the institutions to restructure, raise capital, reduce leverage, divest or downsize.

Thus, rejecting a living will gives regulators an opening to restructure the companies themselves. The 11 bank holding companies have until July 2015 to "rewrite their living wills" to the regulators' satisfaction.

This exercise is complicated by the fact that it is unclear what an "acceptable" living will would look like. Dodd-Frank does not include any objective thresholds or standards for living wills. For example, there is no discussion of the conditions under which the bankruptcy plan must work: in the midst of an economic boom when the firm fails in isolation, or in the midst of a financial crisis when many firms are on the ropes. Two very different situations will require two very different plans.

Moreover, the acceptability of a living will is based solely on judgments rendered by the FDIC and the Board of Governors. There is no judicial review and essentially no way for a designated firm to challenge the FDIC or Board of Governors' opinions as to the acceptability of these plans. Nor can firms challenge organizational changes that regulators may require using this new power.

This type of regulatory discretion is not uncommon in the world, but it is usually found in "banana republics" and countries where the government runs the banking system. Such unconstrained authority opens up all sorts of avenues for partiality and government intrusion into a financial institution's operations.

In addition, the benefits of the living will exercise are far from clear. A recent House Financial Services Committee Republican Report questioned if living wills can even work. The plans are supposed to be a regulatory analogy to pre-packaged bankruptcies, or blueprints for speedy reorganizations using bankruptcy that will keep financial institutions open and operating and thereby prevent financial instability. But this analogy breaks down because living wills lack creditor participation.

The key to a successful pre-packaged bankruptcy is creditor acceptance of a debt-restructuring plan before entering bankruptcy. But bank holding company creditors do not approve living wills; they don't even see them. And the institutions filing the plans are not even obligated to follow them in bankruptcy.

To address these problems, the living will process must be made more transparent and boundaries placed on regulators' discretionary powers. One way forward is to require regulators to provide clear standards for an acceptable living will, and to codify these standards into regulations that apply to all designated holding companies.

Through the guise of living wills, the government currently has the authority to determine company structure, business lines and investments at the most fundamental levels of large financial services firms. Regulators' recommendations are binding and not subject to public comment, nor are they applied equally across all institutions.

This bears little, if any, resemblance to free enterprise.

Paul H. Kupiec, a resident scholar at the American Enterprise Institute, has held senior positions at the FDIC, International Monetary Fund and Federal Reserve Board and served as chairman of the research task force of the Basel Committee on Banking Supervision. Abby McCloskey, program director of economic policy at AEI, was director of research at the Financial Services Roundtable and a staffer for Sen. Richard Shelby during financial reform.

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Law and regulation Dodd-Frank