Living Wills Only Work If Regulators Are Psychic

The yearslong fight over “ending too big to fail” has spilled out of the bar and into the parking lot of the contest for the presidential nomination of the Democratic Party. Sen. Bernie Sanders urges immediate and forceful action. Hillary Clinton, by contrast, puts the issue in the hands of the banks’ regulators charged under the Dodd-Frank Act with implementing a solution to this nettlesome problem.

Now come those regulators with their near-unanimous thumbs down on the living wills of the U.S. institutions deemed the biggest risk to the financial system. Only Citigroup received a passing grade from both the Federal Reserve Board and the Federal Deposit Insurance Corp. The regulators’ findings drive home the point that, eight years after the financial crisis and almost six years after the enactment of Dodd-Frank, the financial system is still vulnerable. The Fed and the FDIC’s findings also shine a harsh light on the core defect in the law.

Dodd-Frank tries to address the systemic risk of the largest firms and its sister issue – TBTF – with four different tools; I call them the Big Four. They are: capital rules, liquidity rules, living wills and new FDIC authority to manage resolutions of failing firms. Each of these tools has some merit. But none of them either alone or in concert are sufficient to address the too-big-to-fail problem.

The tools aim at an uncertain future, not at current conditions. Implicit in each tool is a question. How much capital is enough to protect the financial system in the future? How many assets need to be liquid to protect the system in the future? How can an institution be resolved by global regulators in the future? How can a firm go through bankruptcy in the future without taking down the financial system?

Now, our regulators are dedicated, talented people but they have a miserable track record of predicting future events. The core problem with the living wills, as with the other Big Four tools, is that that they are by definition an attempt at predicting future events.

It is doubtful that the too-big-to-fail banks have the will to devise “credible” living-will plans, since credible bankruptcy plans presumably undermine their mystique of invincibility, making them subject to market discipline just like any other firm. Even assuming they have the will, is there a way? The shifting sands of the Fed and FDIC criteria for submitting a credible bankruptcy plan, and the unpredictability of the various stress scenarios banks must consider in drafting them, make planning for a resolution at some future date almost unfathomable. Add on to that the fact that the whole endeavor is secretive and you’re left with a process that itself is not credible.

This array of Big Four tools based on unknowable future events has enhanced the deep suspicion of a symbiotic relationship between the banks’ regulators and the TBTF banks. They are in this together and the failure of one or more TBTF firms will be equally devastating on both sides.

So what are we to do? Here are two actionable proposals for giving the living-will process more credibility.

First, make the process transparent. The publicly released letters regulators sent to each of the firms on their living-will results contain numerous redactions of key information. Most significantly, the meat of the resolution plans is contained in thousands of pages of documents hidden from public view. Follow the advice of FDIC Vice Chairman Thomas Hoenig and open up the process. After all, if the endgame is to eliminate the perception of TBTF, “Trust us” just isn’t going to cut it.

Second, now that systemic risk has been added to the Fed’s mandate of full employment and stable prices, borrow the “forward guidance” tool from the Fed’s monetary policy toolbox. Nothing would be more meaningful now than a clear message from Fed Chair Janet Yellen that the endgame of the living-will process is not the scripting of playbooks that will never be used. Rather, it should be the dismantling of these firms to the point where neither the regulators nor the marketplace perceives them as operating above a taxpayer safety net.

An even better idea would be to examine empirically how each of the biggest banks is benefiting now, not at some future date, from their market advantage. This is what most refer to as the banks’ “subsidy.” Rather than deluding ourselves into thinking that regulators peering into their crystal balls can come up with a magical fail-safe formula, let’s examine the facts as they actually exist. If it turns out – as it will – that investors, counterparties and regulators are showering financial rewards on TBTF companies, then the path ahead is clear.

It’s a whole lot easier to report on what has happened than to predict what might.

In China, there is no ambiguity when it comes to the four dominant “policy banks.” If any of these large state-owned banks experiences material financial distress in the future it will be bailed out pure and simple by the People’s Bank of China, the country’s central bank. The U.S. financial system shouldn’t be governed by the same approach.

If the candidates in November are truly concerned about the TBTF issue, they would do well to focus on the current moment and not on some vague future time.

Cornelius Hurley is director of the Boston University Center for Finance, Law & Policy and professor at the Boston University School of Law. He is a former assistant general counsel at the Federal Reserve Board.