As the Financial Stability Oversight Council begins work today, living wills are breathing hard. The Dodd-Frank Act mandates these for systemic institutions, although the FDIC beat its regulatory brethren to the punch earlier this year when it proposed its own standards to ensure that a big bank can be put to rest in peace. Global regulators are also pounding on the chest of the living-will concept, with the Financial Stability Board Monday pointing to this requirement as it quietly killed off a global systemic-risk surcharge. So, all are agreed on living wills. Now, the only question is: could they actually work?
A recent Financial Times analysis shows the daunting nature of living wills. It found that Lehman Brothers had 6,500 counterparties across 1.2 million derivatives. Since Lehman went bust in September of 2008, its resolution team has been able to unwind only about a third of these contracts, making a bit of a dent in the $88 billion initially in dispute. Still, two years on and so little done is stark testament of the complexity of big-firm resolutions. Living wills are supposed to cure this, but the complexity of counterparty exposures makes clear that these documents must be as complicated and comprehensive as a bank’s risk-taking warrant. If the living wills falter, new risks will quickly catch up and pose resolution problems just as daunting as those resulting from Lehman’s collapse.
Complex counterparties are only part of the problem with colossal banking organizations. Another is mind-numbing legal structures. Large banking organizations have intricate branch and subsidiary networks spread across the globe, along with untold numbers of minority interests that can’t be easily unwound. Regulatory friends tell us that even initial efforts to plot out the legal structure of complex banks have flat-out failed, with one major U.S. bank holding company apparently even mistaking how many insured depository banks and thrifts it has in the U.S. at the start of the process.
By now, we trust that this bank holding company has checked its call report and counted up all its subs. It and others are also beginning to look under other covers to understand their own bewildering corporate structures. Although everyone seems to know to whom he or she reports, gaps in who is legally responsible for what are, we are told, legion. Counterparty credit-risk exposures are also coming under new controls post-Lehman, including far better legal documentation.
But, counterparties and complexity are only part of the challenge facing living wills. Even if firms count up all their financial contracts and number their domestic and foreign operations, the next question is to what end all this information is put. A complex bank may know after all its work that it’s got a bundle bet on a counterparty or in an offshore subsidiary, but what’s it to do then? If legal barriers or operational confusion at counterparties beyond a bank’s control hinder anticipated collections, access to capital or use of liquidity, the bank’s still stuck.
Regulators are worrying about this problem through ongoing work on cross-border resolution protocols. These are supposed to make clear to all who gets what when, establishing a framework that then permits orderly liquidation. Following all this work, banks and regulators will know on which door to knock for what. This will – it is hoped – end legal barriers and force regulators around the world to address operational risk. Nice idea, to be sure, but a long, long way from fruition. The Monday FSB statement still has cross-border resolution protocols on the lengthy to-do list, with no clear deadline we could see.
This leaves banks told to draft living wills now in a difficult quandary: how are they to plan their own demise when their regulators haven’t figured out which laws apply to whom when or what standards ensure the free flow of funds across national borders in stress scenarios? Absent a clear and binding set of rules that govern the major financial markets, banks can draft living wills all the livelong day, but they still won’t count in a crisis. Putting first things first, regulators should finalize cross-border requirements and then – and only then – require banks to figure out how to protect themselves under various stress scenarios. Without clear guidance on what regulators will demand when, U.S. rules on living wills could do more harm than good, forcing U.S. banks to trap liquidity in their onshore entities out of fear of offshore impediments, worsening regulatory burden, competitiveness and systemic risk at one fell swoop.