Regulators' Rebuke of 'Living Wills' Proves Dodd-Frank Is Working

The Federal Reserve Board, and especially the Federal Deposit Insurance Corp., have demonstrated exemplary leadership in their rebuke of big banks' so-called living wills.

The agencies announced earlier this month that the resolution plans of the country's 11 largest banks were inadequate, concluding that they could not be unwound in an orderly manner without a government bailout.

While many interpreted this as bad news, the good news is that these two bank regulators have taken very seriously their responsibility under the Dodd-Frank Act to protect taxpayers from having to rescue badly managed banks. It is also good news that these bank regulators are putting large, systemically important banks on very public notice that they must take much more seriously their resolution plans.

The purpose of these living wills is to show bank regulators exactly how banks can be resolved in an orderly and timely manner in domestic and foreign jurisdictions without taxpayer support. The living wills are not easy to write because they are very time-consuming and data-intensive. Living wills require that senior executives really understand their companies complex subsidiary structures in multiple geographies. It also requires them to assess whether or not their banks' IT architecture is good enough to provide valid and timely information about where their risk exposures lie, especially those posed by financial derivatives, securitizations, and repurchase agreements.

Regulators essentially said that the banks' living wills were too optimistic in their economic and legal assumptions. That raises questions about the strength of the banks' risk management programs and should leave investors and taxpayers wondering if the banks are simply too big and complex to manage.

Relatedly, the Federal Reserve Board also suggested last week that banks are not prepared for a higher interest rate environment. This is surprising given how long market participants and Federal Reserve officials have been talking about the timing of when rates will rise. Not having a sound strategy for how to cope with major macroeconomic changes adds to the doubt that banks really understand their risk exposures across the globe.

Investors, taxpayers, and regulators should be watching very carefully what senior bank management will do next in continuing to abide by Dodd-Frank's intent of making the financial sector safer. The lowest hanging fruit for the banks will be to close redundant subsidiaries that have outlived their usefulness. A number of the country's biggest banks, including Citigroup and JPMorgan Chase, have hundreds of legal entities spread out over dozens of countries. It is no wonder that banks have difficulty understanding what each entity does, not to mention its level of risk exposure and whether it is sufficiently liquid.

Banks also need to work with the International Swaps and Derivatives Association on finding an industry solution for how long counterparties would be willing to wait in terminating derivatives contracts with a failing bank. This is critical to making living wills much more credible. We saw during Lehman's downfall how much chaos can result when derivatives are not terminated in an orderly manner.

A key element that could make living wills more credible is whether banks will issue long-term debt, referred to as bail-in debt.Especially in light of last week's announcement, it is likely that bank regulators will speed up preparing a bail-in debt proposal so that banks are sufficiently capitalized during a resolution to avoid a government bailout.

Lastly, banks really need to get better legal advice. Despite having spent millions of dollars on hiring legal counsel for advice on cross-border resolution challenges, many bank managers still assumed that foreign regulators would not ring fence good assets if a crisis were to happen. It is difficult to understand why bank management and lawyers would make this assumption. Already in 2010, the Bank for International Settlements published an important paper on regulatory behavior during cross-border crises and ring fencing.  

It is imperative that these living wills be more transparent. We, the taxpayers, had to bail out banks, and we have the right to see if they have made progress in becoming healthier. A gem buried almost at the end of the Fed's press release last week stated that “the agencies are also committed to finding an appropriate balance between transparency and confidentiality of proprietary and supervisory information in the resolution plans. As such, the agencies will be working with these firms to explore ways to enhance public transparency of future plan submissions.” This is an important hint that more transparency may be coming.

Regulators are learning a lot about banks through their living wills; equally senior bank executives should use the living wills to be honest about their risk exposures and their resolution deficiencies. Rather than blaming regulators for pointing out the lack of credibility of their living wills, executives need to confront their numerous challenges in order to protect U.S. taxpayers

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World and The New York Institute of Finance.