Regulators Reject Living Wills of 11TBTF Banks, a 100% Fail Rate

Mirabile dictu, it looks like Elizabeth Warren’s grilling of Janet Yellen on the Fed’s failure to make progress on Dodd Frank resolutions, also known as living wills, has had some impact. From the Wall Street Journal:

In a sweeping rebuke to Wall Street, U.S. regulators said 11 of the nation’s biggest banks haven’t demonstrated they can collapse without causing broad, damaging economic repercussions and ordered them to show “significant” progress by July 2015.

The Federal Reserve and the Federal Deposit Insurance Corp. said bankruptcy plans submitted by big banks make “unrealistic or inadequately supported” assumptions and “fail to make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for” an orderly failure. The regulators raised the specter of slapping banks with tougher capital, leverage and other rules—and even eventually forcibly breaking them up—absent significant progress to address the shortcomings.

The findings applied to 11 banks with assets greater than $250 billion, all of which will get letters detailing shortcomings in their so-called “living wills.” The firms have until July 1, 2015 to file significantly improved plans or face consequences such as higher capital requirements, borrowing limits, or potentially an order to restructure their firm.

Mind you, this is a 100% failure rate. Per the joint statement of the Fed and the FDIC, the regulators issued this verdict on the “second round” of resolution plans submitted by 11 banks in 2013, namely Bank of America, Bank of New York Mellon, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street Corp., and UBS.

We aren’t surprised that the banks were unable to draw up realistic resolution plans. Among the many problems with the Dodd Frank “living wills” process, also known as Article II resolutions, is that Dodd Frank is a US law, when most of these banks have substantial international operations and counterparty exposures. A truly viable resolution plan, among other things, would require each international unit to be separately capitalized and able to fail without impacting other units. This is in opposition to the current banking “home host” regime, in which national regulators generally defer to the regulator of the parent, particularly on capital adequacy. If the national regulator thinks the operations in its country look unduly risky, they could demand that the mother ship send more capital to the local operation. The FDIC, after having an initially unrealistic view of its ability to resolve banks under Dodd Frank, came around to that point of view in 2012. From a post in June:

It’s worth noting that the FDIC has retreated from its position in a paper it published a bit more than a year ago, a description of how it would have used its expanded powers in the case of Lehman. Gruenber’s speech is de facto climbdown from that piece, which we shredded in a series of posts (here, here, here and here; it took that many rounds to beat back staunch administration defender Economics of Contempt.

The guts of the latest FDIC scheme is to resolve only the holding company and keep the healthy subsidiaries, including all foreign subsidiaries, going on a business-as-usual basis:

…the most promising resolution strategy from our point view will be to place the parent company into receivership and to pass its assets, principally investments in its subsidiaries, to a newly created bridge holding company. This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings. Because these subsidiaries will remain open and operating as going-concern counterparties, we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal.

The subsidiaries would be moved over to a new holding company; the equity in NewCo would become an asset of the holding company now in receivership. The old equityholders would likely be wiped out and the bondholders may wind up taking losses.

So the Federal regulators are getting religion and are forcing real change on banks, right? And they are going to solve the TBTF problem for good?

Clearly this is such a departure from business as usual in regulatory circle as to merit lots of skepticism. As our post in 2012 continued:

This all sounds wonderfully tidy and neat, right? Problem is it won’t work.

The rather large fly in the ointment is that counteryparties would be concerned that putting the holding company into what Satyajit Das calls “a strange hypnotized state” would trigger cross defaults across agreements, including derivative agreements, where the holding company had guaranteed a contract. Per Das:

This would mean all derivative contracts could be terminated and this may trigger large payments which the FDIC may need to fund (i.e. is the American taxpayer going to pay out counterparties claims?).

Remember that in the US, banks (ex Morgan Stanley) have their derivatives booked in the depositary, which means any losses to depositors as a result of derivatives positions gone bad would be borne by taxpayers. And as we’ve written at excruciating length with respect to the Lehman bankruptcy, the magnitude of the losses cannot be explained by overvalued assets plus the costs resulting from the disorderly collapse. Derivatives positions blowing out (as well as counterparties taking advantage of options in how contracts can be closed out and valued) were a major contributor to the size of the Lehman black hole.

Moreover, even if this novel procedure did not trigger cross defaults, counterparties to the subsidiaries would seek to terminate contracts. Unless the FDIC (or another government funding source) were to stand behind the subsidiaries, including foreign subs, this attempt at a holding company resolution would trigger the sort of subsidiary level distress that the FDIC intends to avoid. Many banks’ foreign operations have little or no capital in them, relying on a “home-host” arrangement in which the mother ship (the foreign parent) sends more funds and/or capital when local regulators or counterparties require it. Concerns about how badly this model worked in the Lehman failure, when the US parent raided the London broker-dealer in a last-ditch effort to save itself, have led to more regulators adopting a “ring fencing” posture, requiring local operations to be better able to stand on their own. This posture is becoming more widely accepted abroad, in part due to the view of leading international regulators and international bank lobbying groups that Dodd Frank resolutions won’t work, due to the failure of the US law to recognize that bankruptcy (and resolution) falls to nation-based courts. As we noted in an earlier post:

For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ [with the FDIC]. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it “recognizes the strong likelihood of ring fencing in a crisis” due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that “helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.” In other words, it accepts a national process as inevitable and recommends dealing with that reality.

Now admittedly, the public statement makes a gesture at addressing the derivatives problem. From the section of the press release describing what the banks need to do to get a passing grade (emphasis ours):

These actions include:

• establishing a rational and less complex legal structure that would take into account the best alignment of legal entities and business lines to improve the firm’s resolvability;
• developing a holding company structure that supports resolvability;
• amending, on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings;
• ensuring the continuity of shared services that support critical operations and core business lines throughout the resolution process; and
• demonstrating operational capabilities for resolution preparedness, such as the ability to produce reliable information in a timely manner.

Yves again. But notice that the bolded language, if I parse it correctly, requires the firms to develop new standard agreements for derivatives under ISDA. But ISDA has certain master form templates, and there are multiple versions of supposedly “standard” ISDA forms. Moreover, what are these banks supposed to do about outstanding contracts that the regulators deem to be not up to snuff from a resolution standpoint? In addition, as Das stated, a resolution of the holding company is likely to lead to early termination at the subsidiary level when counterparties have that option.

And let’s posit that, contrary to expectations. the authorities are bloodyminded and savvy enough on this issue to force the banks to redo contracts to achieve the intended effect, that counterparties can’t closing out contracts when a firm is put into resolution. This can have two effects: First, it will (as the banks are sure to complain) drive business to banks not subject to Dodd Frank resolutions. Second, in the interest of staying “competitive,” the banks might sneak in provisions that maintain or even improve other termination rights. That could have the perverse effect of making a bank run happen faster, as counterparties close out positions with an institution that looks to be on the rocks.

In general, remember Richard Bookstaber’s observation about tightly coupled systems: that efforts to reduce risk usually backfire. The most important safety measure is to reduce interconnectedness first. Now if the required changes to derivatives contracts are sweeping enough, they could have that effect by making them sufficiently unattractive to counterparties so as to reduce their use. But I”m not betting on that outcome.

So while this unexpected show of spine is welcome, it remains to be seen how much in the way of structural changes and higher capital levels the authorities will demand. And even if they make progress in that direction, the current derivatives regime pretty much assures that any bank with significant exposures is still too complex a bomb to disarm.

But there actually is a perverse way that even partial reforms could prove more salutary than expected. If the Fed and FDIC were to unexpectedly stick to their guns and demand more balkanization of operations and more capital in the major subsidiaries, that will make a dent in bank profits. Less egregiously profitable banks means they are less attractive destinations for the sort of “talent” that blew up the global economy. Indeed, it’s even conceivable that progress in this direction would mean that more top undergraduates and graduates give serious consideration to careers in the real economy.

So while this stinging, public rebuke is welcome, only time will tell whether this development is merely regulatory kabuki or that continued public concern about the TBTF issue means the bank skeptics like Tom Hoenig at the FDIC have been able to carry the day in internal debates. Irrespective of how this living wills decision came about, it will take continued public pressure to keep the authorities from following the path of least resistance, namely, backsliding.