The Hidden Positives in Big Banks' Awful Living Wills

WASHINGTON — On the face of it, federal regulators' rejection Wednesday of five megabanks' resolution plans was a stunning rebuke after years of work between the banks and the agencies and further evidence that they remain "too big to fail" more than eight years after the financial crisis.

Yet the bad grades and detailed laundry list of fixes that institutions must make in the next five months — or face possibly severe consequences — may actually prove helpful in the long run, both to the debate over "too big to fail" and the banks themselves.

For the first time, the Federal Deposit Insurance Corp. and Federal Reserve Board made public specifics about the failings of each bank's living will that they submitted last year. While the feedback is harsh, it is also a critical step toward helping megabanks simplify and streamline their operations, according to experts.

"It's very clear that they sat down and wrote letters specific to each different entity," said Rebecca Simmons, a partner at Sullivan & Cromwell.

The individual letters, ranging from nine to 30 pages, provided a detailed critique of the liquidity, operational, legal and other obstacles the firms failed to address in their resolution plans. (For details on what each bank did right and wrong, click here.)

"The deficiencies are very specific to the institutions and are technical in nature," said James Wigand, a partner at Millstein & Co. who served as the FDIC's first director of the Office of Complex Financial Institutions.

Regulators' decision to come out jointly against five firms — another first since the process began in 2011 — also "signals a paradigm shift," said Karen Shaw Petrou, the managing partner of Federal Financial Analytics. This time, she said, the regulators were willing to use "actual binding standards that force structural change."

The FDIC found most banks' living wills noncredible in 2014, but the Fed disagreed. As a result, regulators did not start a regulatory clock that would give them authority to impose stricter standards. On Wednesday they warned that if the banks did not fix flaws before Oct. 1, they would take action.

But the agencies were also more careful to explain the rationale of their decisions, and give banks what they consider a realistic timetable for righting their plans. They gave banks a little relief by allowing them to skip filing new plans this year, but instead focus on fixing problems with last year's plan before crafting their next round by July 2017.

"One thing that is consistent is the agencies have kept a focus on achieving resolvability by 2017," said John Simonson, a principal at PwC.

Regulators may also have wanted to provide more details given a recent ruling against the Financial Stability Oversight Council in court. A federal judge criticized the FSOC's reasoning for designating MetLife as a systemically important financial institution, in part because it did not provide enough specifics to justify its actions.

"I think it appropriately put the Fed and FDIC on notice that rulings, especially those of the strategic significance of the living wills, that don't stand up to that kind of analytical rigor could be subject to challenge," said Petrou.

Agency officials stressed that the determinations did not reflect a higher standard this time around, but that they would adjust their judgment for every iteration, as was mandated by the Dodd-Frank Act.

Eugene Ludwig, a former comptroller of the currency, noted that regulators also cited improvements in each of the banks' plans. At the same time, they clearly set a high bar for passing.

"They are really saying you've done a good job in a lot of areas, but our curve in the exam is way high," said Ludwig, the founder of Promontory Financial Group. "If you are really trying to assure the public that banks are not 'too big to fail,' it's not surprising they would say at this round we want a class of all As. We don't want a class of B-minuses."

Wigand said regulators are dialing up their expectations and feedback.

"With each round, the expectation is that the Fed and the FDIC would become more both specific and grade with a higher expectation that the plan is more robust," Wigand said. "The expectation now is that the plans need to be credible."

But not everyone had such a positive view of the results.

For some, the failing grades indicated that regulators had moved the goalposts in part to ensure that some banks failed. They pointed to Wells Fargo's failing grade this round after it was one of the only banks to get a thumbs up from both regulators in the previous one.

"How did Wells Fargo pass [in 2014] and then all of a sudden fail?" asked a senior financial industry aide, who spoke on the condition of anonymity. "If regulators changed their own mind about what they wanted to see, is that Wells Fargo's fault?"

Another expert, who declined to be named when discussing a specific institution, said that in the case of Wells Fargo, regulators had initially sought to make a point that its structure lent itself more easily to resolution.

"The structure of the institution itself is less complicated and therefore the number of issues that need to be addressed is not as widespread as what some other institutions need to cover, but it doesn't mean the plan itself was credible," the expert said.

Wells may also have been guilty of resting on its laurels, some said. A senior agency official speaking to reporters on Wednesday emphasized that the living wills aren't meant to be placed on a shelf when finished, but evolve as the institution does.

It's worth noting that Citigroup — widely considered one of the more complicated megabanks — managed to score the only passing grade from both the FDIC and Fed. That shows that regulatory expectations are realistic, some analysts said.

"Citi is often thought of as being one of the more complex U.S. banks," a KBW Research memo noted. "But the resolution plan seemed relatively simple to us."

For some, Citi's good finish was proof that single-point-of-entry strategies, which rely on the bankruptcy of the holding company while important subsidiaries are maintained up and running, are viewed more favorably by regulators.

But in their letters, regulators questioned both the single-point-of-entry and multiple-point-of-entry strategies.

"They have questions on all types of strategies, and it is clear that they are ... measuring whether the strategies meet the statutory standards," Simmons said. "They have not prejudged whether one strategy is statutorily acceptable."

Overall, the divergent results reflect that regulators are now as focused on the viability of a firm's plan as they are on their structural ability to undergo resolution.

"The firms are in different stages so there's a spectrum of results," said John Corston, an independent senior adviser at Deloitte and former associate director at the FDIC's Office of Complex Financial Institutions. "This really reflects the next phase, as the agencies now have felt more comfortable giving more specific feedback."

But there are a number of critical questions still left over, among them what regulators will do if the banks do not fix flaws by October. Many agreed that will be the next critical test of the process.

"It will be dependent on the individual institution and its circumstances," Ludwig said. "These plans are not cookie cutter because the banks are not cookie cutter."

"This is a very, very big deal," Ludwig added. "It's a bigger deal even than [stress tests] in terms of these institutions and the shape of the American banking system. Because if the regulators truly believe an institution or institutions do not pass the bar and remain 'too big to fail,' the regulator has to take serious action — and that action can be quite draconian."

One thing is already clear: The results have provided ammunition for both sides in the debate over "too big to fail."

Sen. Elizabeth Warren, D-Mass., called the results "scary."

"Unless these banks promptly address the concerns identified by the regulators, the government must push these banks to get smaller and less complex," she said.

Democratic presidential candidate Hillary Clinton agreed it is time for regulators to act.

"For the banks that didn't pass muster and are unable to resubmit credible plans, regulators need to protect the American public and follow Dodd-Frank by taking actions like imposing higher capital requirements and restricting their activities," Clinton said. "And if these banks don't fix their problems over time, then regulators need to break them apart."

But others saw proof that the post Dodd-Frank regime was working.

Joe Fellerman, a former special adviser at the FDIC's complex-institutions office, noted that "regulators in the past have been reluctant to take the hammer that Dodd-Frank gave them."

"I'm pretty impressed that they're assaulting the firms like this," he added. "It was almost an indictment on the industry that after four tries of resolution plans the firms just aren't getting it."

John Heltman and Rob Blackwell contributed to this article.