By: Luis Calvo
On July 2, the Federal Reserve released public versions of the resolution plans or “living wills” of nine large banks. Living wills contain a blueprint of large financial institutions to be used to determine how the institution would maneuver financial instability without affecting the market at large.
Section 165 of the Dodd-Frank Act imposed numerous rules on banks and bank holding companies to avoid the “too big to fail” market hazards caused by the Lehman and Bear Stern collapses.[1] These new rules included capital and liquidity requirements, stress tests, overall risk management requirements, and concentration limits, among others. To help regulators monitor new requirements, section 165(d) orders certain banks and bank holding companies to periodically report to regulators their plan for “rapid and orderly resolution in the event of material financial distress or failure.”
Under the implementing rules, living wills submitted to the Federal Reserve are meant to be works in progress. Once submitted, the Federal Reserve has 60 days to use its examination authority to determine whether banks satisfy the requirements. The Federal Reserve will then share with the covered institutions its assessment of the their compliance. Notably, banks must submit confidential and public versions of their living wills.
As with other Dodd-Frank provisions, the implementation of living wills has faced criticism. Some openly wonder what “material financial distress” means, how the Federal Reserve will determine obligations for ongoing disclosure, or (most importantly) how the Federal Reserve will protect the banks’ confidential information. Others have more practical concerns, such as the lag time between data collection and reporting. Perhaps the most pointed critique is a lesson learned from 2008: living wills are ineffective in the face of a systematic market failure. That is, living wills work if the bank, and only that bank, fails. If there is widespread economic failure, there will be no market for the failed bank’s assets.
Other observers have welcomed living wills as an opportunity for banks. These optimists see living wills as an occasion for banks to allocate resources towards designing “worst case scenario plans” and educate bank insiders should their institutions become financially distressed. As such, living wills present a chance for banks to “reflect and improve” their business to avoid a doomsday scenario.
These initial nine banks will serve as test cases for critics and supporters of living wills. By the end of 2013, 125 banks are expected to submit and publish their living wills. In the meantime, faced with the upcoming public disclosures of living wills, some propose avoiding buying stock in banks with living wills. It remains to be seen how regulators will react to the submissions of banks thus far. As for investors, ultimately, public disclosure of living wills increases publicly available information. It is up to the investors to judge these disclosures for themselves.
[1] See page 48 of attachment.
