Tougher Reviews, Disclosure Debate Highlight New Phase of Living Wills

WASHINGTON — The first two years of a requirement for large firms to draft "living wills" almost felt like a dress rehearsal, but that appears likely to change in 2014.

The New Year promises more rigorous grading of banking companies' updated resolution plans than how regulators treated their first submissions, the inaugural filings of three nonbanks firms recently designated as "systemically important," and continued debate over how much of the wind-down plans should be public.

"They didn't get a tremendous amount of feedback in the first go around," said John Corston, a director at Deloitte and a former associate director in the Federal Deposit Insurance Corp.'s complex financial institutions section. "There is an expectation that there will be more meaningful feedback by the agencies to the institutions."

The FDIC and Federal Reserve Board are currently reviewing the second drafts for 11 of the largest firms, which were the first to submit initial plans in 2012. The reviews aim to assess how easily a firm could be unwound in bankruptcy. That is in contrast to the first drafts, which were largely graded for completeness. Under the Dodd-Frank Act, the two agencies can take actions against companies if their plans are considered subpar.

"Unlike the first round, this round of plans will be subject to evaluation under the standards of the statute, which is resolvability under bankruptcy. I view that … as an important work in progress and in some sense the first real test of this process," FDIC Chairman Martin Gruenberg said last month at a meeting of experts who advise the agency on its resolution procedures.

Resolution planning is now a reality for about 130 firms, from big names like JPMorgan Chase (JPM) and Bank of America (BAC) to more obscure foreign banks with limited U.S. activities. The aim of the living will process is twofold: compel institutions to think about steps to simplify their structure, and help provide a roadmap to the FDIC in the event the agency ever has to exercise its new resolution powers to clean up a failed behemoth.

All firms have submitted first drafts under a staggered deadline schedule, but those initial plans were essentially just to get companies familiar with the process. But with all filers required to write annual updates, the attention has now shifted back to the most complex companies that had submitted first drafts in July 2012.

Those 11 filers — including JPMorgan Chase, B of A and Citigroup (NYSE: C) — are now awaiting a response from the regulators to their second submissions that were delivered in October, and are also in the process of writing third drafts due in July.

Meanwhile, the four firms in the middle — including Wells Fargo, which is considered less complex than the top-tier filers despite its size — must submit their second drafts in July. The agencies just Friday posted public portions of the first living wills that the roughly 115 firms in the last tier had submitted at the end of December; they will file updates by the end of 2014.

The agencies are expected to begin assessing the initial second-round plans more critically to gauge whether institutions' scenarios for how they could be unwound is credible. The Fed and FDIC issued guidance in April for the second filings, requiring, for example, that firms state in detail how they would remediate obstacles to an orderly resolution. According to an FDIC spokesman, plans must include analysis on how a firm's resolution plan addresses "global cooperation with foreign regulators, multiple insolvencies of subsidiaries, counterparty derivative actions, maintenance of critical operations, and funding and liquidity."

"It's going to be an important pressure point for the big banks," said Simon Johnson, former chief economist of the International Monetary Fund and now a professor at the MIT Sloan School of Management.

Yet what form the agencies' feedback will take exactly is still unknown. Some with knowledge of the evaluation process have said privately that, broadly speaking, all 11 plans demonstrated significant improvement compared with the first drafts and appear to follow the principles of the guidance. But it is unclear exactly how definitive the agencies will be in their responses.

Dodd-Frank gave the two agencies substantial powers to penalize banks for flawed living wills — including forced asset divestitures to simplify structures of firms with continually subpar plans — but many observers doubt the agencies will approach that level of punitive action in the second round.

"Most banks have tried very hard to come up with plans that will work. The proof of the pudding will not be in the eating but in whether the Federal Reserve and the FDIC think they've been properly baked," said H. Rodgin Cohen, senior chairman at Sullivan & Cromwell LLP.

But how far the agencies go in their determinations about a plan's credibility "is a major question mark," he added.

"Personally, I would be very disappointed if the living will were used at this point in time to force any significant restructuring," Cohen said. "I don't think that is what Congress intended. … They would not do it this early, and I think they would not do this absent egregious circumstances."

Still, he lauded the process thus far, saying that banks have found it useful.

"I was very dubious about the living wills and I think many bankers were. Notwithstanding all the time, effort and resources that is required for this, most banks have found the process to be a salutary one," Cohen said.

Meanwhile, as more banks update their plans, and regulators become more focused on judging individual living wills, many stakeholders and outside observers continue to debate the parameters of the filings. A central issue has been how much material banks include in the public portion of their plans to give investors and other interested parties a sense of their resolvability.

Even though the statute and regulatory policy allows institutions to include only information that has been disclosed elsewhere, many experts say the existing disclosures undermine a process that was supposed to convince the market firms could be unwound without a government bailout.

"It's important for the public to have enough information to judge that the FDIC could credibly plan to resolve these institutions," said Donald Kohn, a former vice chairman of the Fed and now a senior fellow at the Brookings Institution. "The tension I see is you want to protect the privacy of business plans and business strategy of an organization, but at the same time have enough transparency that people can make this judgment. It's analogous to the amount of transparency in the stress tests."

At last month's FDIC advisory committee meeting, Richard Herring, a professor at the University of Pennsylvania, was particularly vocal about the need for more substantive public releases.

"I have to say, at the end of the day, I learned almost nothing," Herring, who has reviewed plans currently in the public domain, said at the meeting.

Herring sits on the Systemic Risk Council, a non-governmental body founded by former FDIC Chairman Sheila Bair, which tracks how the regulators are implementing Dodd-Frank. In December, the council sent a letter to Gruenberg and Fed Chairman Ben Bernanke arguing for more disclosure.

"Unfortunately, the public portions of living wills have been disappointing," the council wrote. "They are not comparable, lack crucial data for understanding" a large and complex financial institution's "business and structure and are little more than selective, idiosyncratic reiterations of existing public information."

But others say the line between information useful to the public and that which could compromise trade secrets and sensitive supervisory material is a fine one.

"These are plans for the regulators. They are not plans for the marketplace," Cohen said. "They are not plans for competitors. And they are not plans for those who have the position that large banks should be broken up. That's not the objective here."

Still, officials have sounded open to limited changes, including the development of a more consistent reporting format to make it easier to compare public plans between institutions. (Any change in what banks including in the public portions would likely require new guidance or a rulemaking.)

"There is a proprietary information issue" but "what you're raising among other things is consistency across the information disclosed in the public plans and identifying those things that could be made available in the public plans," the FDIC's Gruenberg said at the meeting. "There would be real value in that and value in us focusing more on that."

In a statement emailed to American Banker, the agency's spokesman said the FDIC "believes that [added transparency] merits consideration, and we are open to evaluating what could be done to make the process more transparent."

The year will also feature the entry of three new participants in the process. The three nonbanks — American International Group, General Electric Capital and Prudential Financial — that were recently designated as "systemically important" by the Financial Stability Oversight Council will submit their first drafts in July. (The designations subject the firms to a new Fed supervisory regime for giant nonbanks established under Dodd-Frank.)

Like other companies that had to meet a low bar for their first submissions, the three firms will essentially only be judged for informational completeness in mapping out their internal structures.

But observers say the nonbank plans will still be important in the first round, giving the bank regulators a window into operations they are less familiar with than traditional banks.

"The resolution planning process may actually aid" the Fed in preparing a new supervisory structure for nonbanks, said Rebecca Simmons, also an attorney at Sullivan & Cromwell. "In many ways this is their first opportunity to dig deeply into how these companies are actually run and therefore create a regulatory regime that is appropriate."