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When you plan to fail, you fail to plan

The US Federal Reserve told 11 banks last week that they had failed utterly to draft so called living wills — plans for how they would raise capital in a crisis and how they could be resolved in a hurry if they go under. It was right, they had failed. But the whole concept of living wills is shonky.

When the Federal Reserve and the Federal Deposit Insurance Corporation told 11 banks that their living wills were woeful, plenty of people drew the conclusion that the process has been appallingly stage managed.

The regulators and regulated are supposed to be in close contact. For 11 systemically important institutions, hopefully the Fed has good communication channels, and these run both ways. It shouldn’t be about filling in occasional box ticking exercises and posting a questionnaire every month. These are the most complex financial institutions in the world and the Fed has a duty to know what they are up to.

So a drawn-out public process of trial and error should not be how banks learn to write their living wills.

This is supposed to be a part of ending “too big to fail”. If a bank can envision how it could be resolved, then regulators can have confidence in this process, burn creditors, create new good banks or whatever else is needed. Big banks will be able to fail (or rather, be resolved) without a disorderly multi-year bankruptcy, meaning banks' liabilities can be priced their liabilities without state support.

But the banks could scarcely have got it more wrong (despite this being the second attempt at submitting the plans).

The Fed said all of the plans had “assumptions that the agencies regard as unrealistic or inadequately supported… and the failure to make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for orderly resolution.”

The FDIC board of directors said “the plans submitted by the first-wave filers are not credible and do not facilitate an orderly resolution under the US bankruptcy code.”

Harsh judgement from the regulators may have a political motive. If the banks cannot jump through the living will hoop, this adds credibility to calls to break them up. Too big to resolve could be considered too big to exist.

This is not what planning means

But conspiracies aside, the task is a near-impossible one, which elevates the concept of planning far beyond what it can bear.

The banks are being asked, in essence, what they would do if everything they plan to do fails. But no bank plans to run out of money; no bank plans to turn to public funds, and presumably if it does so, it is down to an event that it did predict or account for. If a bank finds a huge trading loss buried somewhere, or that a book of assets it thought were great are near-worthless, that isn’t because it planned to have poor risk controls, or planned to buy rubbish assets, and if it doesn’t have enough capital to cover whatever goes wrong, that probably wasn’t in the plan either.

It’s like asking a job applicant at interview what their plan would be if they got the job, then were fired, became homeless and turned to alcoholism. Their only possible response would be to deal with the situation as best they could.

It isn’t even clear why bank management is being asked to do this. The purpose of the living will is to protect the rest of the financial system from the effects of a bank resolution but virtually the only thing you can be sure of in a big bank resolution is that the management of the resolved bank are not going to be allowed anywhere near the rest of the financial system for a good while.

There are some sensible concepts hiding inside the living will idea. Two suggestions the joint US agencies make are for a simpler legal structure at the big banks and a way around early termination rights in derivative contracts, which will mean that counterparts close out contracts to the disadvantage of the bank in resolution. They also encourage “the ability to produce reliable information in a timely manner”, which it is hard to disagree with.

But why package these in the nonsense of a living will? At best, the living will crusade will do no lasting harm; more dollars down the compliance drain, a heavier burden for banks and regulators but little lasting harm. But at worst, sensible measures that might ease a big bank resolution will drown under the challenge of chasing the living will.

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