Living-Will Grades for Foreign Banks Are Already Obsolete

WASHINGTON — The living-wills process remains a guessing game for the largest, most complex financial institutions, which are still awaiting regulators' evaluation of last year's effort even while they prepare for a new round of submissions due in July.

But for foreign banks, this year's cycle is extra complicated. On the same month they are required to file their 2016 resolution plans, they must also complete a restructuring of their U.S. operations under an intermediate holding company.

"This is a race to get everything legally organized and have systems, IT and reporting in place under an IHC by July 1, while simultaneously having to do a living will," said Sally Miller, chief executive of the Institute of International Bankers.

The living wills were conceived as an iterative process, a back-and-forth between regulators and banks, which are required to redraft a new plan every year to account for changes in the regulatory and economic environment, as well as their business structure.

But feedback from last year's plan is already so late that most banks can't incorporate in a meaningful way into the 2016 living wills. For foreign-based companies with more than $50 billion in nonbranch U.S. assets that will be required to set up an intermediate holding company, it's even worse. Last year's plans now refer to an entirely different business model than the one they are required to put in place by July of this year.

"They're supposed to be filing the living wills right at the same time that they'll be flipping the switch on the IHC," Miller said.

Foreign-based banking institutions are also disadvantaged in the living wills process because they tend to be structured differently from the U.S. banks where regulators have centered their focus.

Generally speaking, foreign-based banks are more decentralized, structured around multiple subsidiaries rather than a single holding company with multiple branches. This has given them a degree of resiliency to financial instability across global markets.

"If Argentina melts down, it doesn't really matter for HSBC London," explained an expert at a consultancy that advises banks, who spoke on condition of anonymity. "Call it an accident of history. You can get global either way," but "it changes how you think about resolution."

According to experts, U.S. regulators appear to favor the single-point-of-entry strategy, a process developed by the Federal Deposit Insurance Corp. as a way to place a bank under the agency's receivership and keep it running as it winds it down under Title II of the Dodd-Frank Act.

Using the single-point-of-entry method, a failed holding company's assets would be transferred to a bridge bank, which would allow all or most of the subsidiaries to keep running while the company is liquidated.

"A single-point-of-entry strategy for institutions is typically easier to address," said James Wigand, a former deputy director at the FDIC and now a partner at Millstein & Co. It's "one failure as opposed to multiple failures."

Focusing the wind-down through a single structure significantly reduces the legal wrangling and costs associated with bankruptcy.

"You don't have multiple competing insolvency proceedings which by their very nature results in creditors and administrators… litigating one another to challenge who owns what," said Wigand.

But foreign banking organizations have struggled to adopt such a strategy because of the more contained nature of their subsidiaries. Instead, some of these companies have laid out a process in which important subsidiaries such as broker-dealers go through separate bankruptcy proceedings.

"Structures of several of the foreign banks doing business in the United States generally presume multiple point of entry," said Karen Shaw Petrou, managing partner at Federal Financial Analytics.

Regulators have not explicitly indicated that they would favor one strategy over the other, but many believe there is one. That may be untrue, some said.

"We keep hearing a rumor that banks are being encouraged to do an SPOE strategy," said Rebecca J. Simons, a partner at Sullivan & Cromwell. "The question has to be whether the strategy meets the statutory standards, not whether the strategy is SPOE or MPOE."

John Lane, a former deputy director at the FDIC and now a special adviser at Promontory Financial Group, however, said he believes "the FDIC recognizes that MPOE has a place. It all depends on the structure of the company."

But forcing foreign banks to form an intermediate holding company effectively gets them away from the multiple point strategy.

"Having only the intermediate holding company going through an insolvency process is effectively a single point of entry within the U.S.," Wigand said. "Those intermediate holding companies will have to maintain or satisfy certain capital liquidity requirements which could be used in a resolution process here or which would insulate the U.S. operations from failure in the event that the parent company does fail."

Even then, however, other complications will arise. Though the intermediate holding company is designed to mimic U.S. bank holding structures, they will likely not encompass all the assets foreign banking organizations have to account for in their living wills. Specifically, branches of foreign companies — a common source of worry for regulators, because they tend to be heavy on assets while facing lighter regulatory requirements — would have to be part of the resolution plan, even if they remain outside of the intermediate holding company.

Moreover, foreign banking organizations face a more complex regulatory environment, which must be taken into account in their plans. There are ongoing concerns about ringfencing and what regulators are going to oversee the resolution of U.S. branches of overseas companies.

"You don't have the advantage of the degree of regulatory cooperation that exists" among global regulators in a receivership scenario, Wigand said.

Those issues needs to be addressed in the living wills, Simons said. U.S. regulators worry that a home country could drain the assets of its U.S. presence in the event of a failure, leaving the FDIC on the hook.

"The U.S. regulators require you to assume that home country liquidators are going to look after the home country, and may leave the branches high and dry," Simons said.

Moving to an intermediate holding company structure will help foreign banks develop resolution plans that conform more closely to their U.S. peers.

"There is additional work in consideration that the [foreign banking organizations] have to take into account in 2016 and going forward," said John Simonson, a principal at PwC. But "there may be a silver lining, because that IHC structure may actually help in terms of resolvability."