Banks, Regulators Face Critical Test in Living Will Results

WASHINGTON — The stakes for big banks — and regulators — are high as the agencies near the release of their evaluation of the largest institutions' living wills.

The Federal Deposit Insurance Corp. and Federal Reserve Board are expected to unveil soon how 12 of the largest and most complex banks did on detailing ways they could be taken account during a crisis. If both agencies determine that any of those plans are not up to snuff, they would start a regulatory clock that could ultimately result in regulators forcing the institution to break itself up.

"The latest submissions and the response of the Fed and the FDIC to those submissions, the importance of it cannot be overstated," said Dennis Kelleher, president and chief executive officer of the public interest group Better Markets.

But the pending release is a critical test for the regulators too. Last time around, in response to plans that were submitted in 2013, the FDIC and Fed disagreed on the adequacy of the plans. The Fed wanted to give the banks time to fix their plans before starting the regulatory process that could result in harsh supervisory actions, while FDIC officials suggested that clock should start then for 11 banks, with the exception of Wells Fargo. Ultimately, the two agencies cut the banks a break, but warned the institutions to significantly improve their plans before the 2015 submission, suggesting they would not be lenient next time around.

Observers are also waiting to see if the FDIC and Fed agree on further action — and just how tough the two agencies are willing to be.

If they are too tough, they risk looking like they are holding banks to unrealistic assumptions. But if they give every bank a free pass, the optics could be equally bad, fueling common campaign rhetoric in the 2016 presidential race that the regulators are too easy on the largest institutions.

"We not only have the credibility of the banks on the line this time, but the credibility of the Fed and FDIC are on the line as well now," Kelleher said.

But Aaron Klein, a director of the financial regulatory reform initiative at Bipartisan Policy Center, insisted regulators would not be influenced by politics.

"The regulators view this as a long-run game in which they are constantly working to improve the living-will product and get it to a position that they are comfortable with," Klein said.

Observers also noted that the latest submissions include significantly more detail than their previous rejected plans and there has been more communication between regulators and the banks on the process.

"August 2014 was kind of traumatic for everybody, so, given the extensive work between banks and regulators since then, we are betting and believing it will be different this time," said Hu Benton, vice president of banking policy at the American Bankers Association.

Unlike last time, in which all the banks but Wells Fargo were largely lumped together (Wells' plan was reviewed more positively), regulators are expected to differentiate more among the firms.

"One of the questions is how individualized are the determinations going to be, and I think we have seen a movement arguably towards more individualization of the reviews on a firm level over time," said Bimal Patel, a financial services lawyer at O'Melveny & Myers, who was previously an adviser to former FDIC board member Jeremiah Norton. "If you are at the bottom of the curve and you miss the mark there is going to be more pressure on the agencies to engage the statutory process."

Robert Burns, a director with Deloitte Advisory and a former deputy director for complex financial institutions, said that it would be "very valuable for the industry" to have more specific feedback from regulators that could make it easier to address any shortcomings.

Another unknown is how much detail the regulators will make public. Bankers argue that the resolution plans contain vast amounts of proprietary information and the regulators should be careful in what they say publicly.

Yet if regulators keep the process behind closed doors, there will be no opportunity for outsiders to assess the credibility of the exercise.

"Part of the problem is that the process is incredibly opaque to the public," Kelleher said. "Unfortunately that means that it is impossible for the public or for market participants to evaluate the living wills."

Some said the regulators could use a model similar to the Fed's Comprehensive Capital Analysis and Review stress tests, in which they explicitly detail a firm's performance.

But Patel said regulators could also err on the side of the more "traditional supervisory process without much public disclosure of the agencies' findings."

Klein pointed to the public portions of the living wills that are already available, noting they had improved from their last iteration.

"The improved quality in public section of the living wills is likely an indicator of an improvement in the private section," Klein said.

Regulators also may be more comfortable with the plans because they have had more time to build out the process for dealing with and potentially dismantling a systemically important institution.

Most recently, the Fed finalized a long-term debt and equity requirement known as total loss absorbing capacity, which is used as a capital buffer to facilitate a resolution. Major international banks have also agreed to an International Swaps and Derivatives Association protocol that imposes 48-hour stay for cross-border financial contracts in order to avoid a Lehman Brothers-like panic.

"There has been a transformational change in the United States and internationally since the financial crisis in regard to the resolution of systemically important financial institutions that perhaps has been underappreciated," FDIC Chairman Martin Gruenberg said in a speech in May.

Randall Guynn, a partner at Davis Polk, noted in a November presentation at The Clearing House annual conference that banks have also undergone significant structural changes, including having roughly more three times the amount of liquid assets that they had in 2008 and reducing their reliance on short-term wholesale funding.

A number of the banks have also adopted a "single point of entry" resolution strategy, which is the FDIC's preferred method to dismantle a bank.