Picking the way one wants to die in a living will is, at best, interesting. But, as people, we at least know the inevitability of the end and the decisions that will need to be made. Not so for global financial institutions or their regulators. Planning for all the events that could fell a systemic institution is like running one’s life in the expectation of getting hit by a bus. Of course, then a living will is no good at all – the challenge at this point is just to pick up the pieces.
The Dodd-Frank Act not only forces planning for an end that might not come or could not be managed when it does. It also lets regulators knock off a bank even if it’s just because they don’t like the way it stands at a cross-walk. The law tells regulators to rewrite a financial company’s structure if they don’t like the look of the living will. This is the first time that Congress has granted U.S. regulators the power to redesign a big financial firm absent any clear showing of profound prudential risk. The prompt corrective action rules give bank regulators a lot of clout, but only when a firm is in extremis. Now, a bank can be fully viable and even quite profitable, but regulators can pull the plug if they think its lifestyle is long-term unhealthy. This is like euthanasia for those who eat too much junk food, or to be less severe, mandatory liposuction. Proponents of living wills argue this is warranted because taxpayers pay the funeral expenses, but under Dodd-Frank, they don’t.
All of these issues will come before the largest U.S. financial institutions on Tuesday, when the FDIC looses the living-will proposal mandated under the Dodd-Frank Act. We’re not in any way opposed to planning for all the evils that could befall a systemic financial company. Like living wills for ourselves, we know they’re a good idea much as we hate to think about it. The problem for financial companies is, though, to know precisely for what to plan. This is an especially formidable challenge given the vast uncertainties still bedeviling efforts to identify systemic firms and, then, to figure out how to ensure orderly cross-border resolution for them.
One key question: for what should a U.S. systemic firm plan? Resolution of its individual parts under the resolution regimes in place for them – the FDIC for banks, SIPC for the broker-dealer and state guaranty authorities for insurance companies? If so, how to reckon with all the complex cross-dealings among these relatively simple parts of a complex financial firm? Cut them off as some living-will advocates propose? This is a darn sight simpler, but also cuts out the heart of the strategic planning that underlies most diversified firms.
And, even if we know where all the pieces are in regulated firms with known resolution schemes – which we don’t – what about the parent firm and all its other affiliates? Dodd-Frank dictates that the living will plan for death at the hand of the Bankruptcy code, not the orderly liquidation authority provisions in Title II. This is rough justice designed to block any hope of a bail-out. But, this requirement has two consequences, both of them likely unintended despite all the zeal to squash too-big-to-fail banks.
The first perverse result of living wills premised on bankruptcy is that it essentially forces a still-breathing systemic firm into a casket of its own design. No other operating entity is required to run itself every day as if it could die by nightfall. To do so is to challenge the fundamental structure of a privately-held company to take reasonable risk in hopes of sensible return. That balance of course got way out of whack before the global financial crisis, but it’s still the right one, even for systemic institutions.
Importantly, living wills aren’t the same as recovery plans. These were done by most large banks after 9/11 or they should have been. Recovery and business-contingency plans are a vital way to ensure the global financial system stands firm against the operational risk of events ranging from manmade and natural disasters – Japan of course a recent, tragic example – to a firm’s own flawed internal controls. Recovery plans aren’t, though, plans on how to put a bank out of its misery; rather, they are designed to ensure that the misery resulting from a systemic event is short-lived and contained. They don’t tell the bank how to shut itself down – the living will – but rather how to keep itself alive to do business another day.
The second perverse result of living wills now is their asymmetric implications for systemic firms in the U.S. In the land of the free and the brave, we’ve decided on an end to TBTF even as the home nations of other systemic firms have decided to memorialize it by figuring out some way to tax big firms for it. Under Dodd-Frank, systemic firms in the U.S. will pay this freight – indeed, they’ll do so even if other nations fail to live up to the proposals now under consideration for systemic surcharges and the like. And, in the U.S. systemic firms will not only pay for the privilege of being systemic, but then get this privilege summarily withdrawn from them in a living will premised on their ability to fail without flaw.
So, what to do? To force systemic firms to enhance transparency, reduce complexity and buttress their prudential insulation all make eminent sense. And, of course, all this and still more is being implemented through both Dodd-Frank and the new global regulatory framework. Is this new systemic architecture sufficiently robust? Probably not, especially in the absence of practical and clear cross-border resolution protocols. But, to add living wills that are essentially funeral plans atop all these other, tough requirements is yet another piece of the pile-up of pronouncements that will restructure global finance in ways still not anticipated, let alone understood.