Coverage: Banks still too big to fail

Banks still have a long way to go when it comes to the safety of the system, and regulators aren’t pleased with the progress they’re making.

Bloomberg’s Jesse Hamilton reported that 11 of the biggest banks aren’t doing a good job figuring out how to unwind safely:

Wall Street banks spent two years asking U.S. regulators what they should put in hypothetical bankruptcy plans to prove they aren’t “too big to fail.” The agencies broke their silence yesterday with a grade: Fail.

The Federal Reserve and Federal Deposit Insurance Corp. told 11 of the largest U.S. and foreign banks, including JPMorgan Chase & Co. and Goldman Sachs Group Inc., that they botched their so-called living wills. The agencies ordered the banks to simplify their legal structures and revise some practices to make sure they can collapse without damaging the wider financial system.

“It’s unfortunate that there have been public findings before there has been any substantive communications with the banks,” said Rodgin Cohen, senior chairman at Sullivan & Cromwell LLP, which has several of the affected banks as clients.

The living-wills exercise was a key check on large banks written into the Dodd-Frank Act, a regulatory overhaul prompted by the 2008 financial crisis. Lehman Brothers Holdings Inc. provided the horror story for what happens when big, complex financial firms land in bankruptcy court. So the regulators yesterday directed the banks to take immediate action to make their holding companies easier to dismantle before their next round of annual filings in 2015.

Victoria McGrane and Ryan Tracy wrote for The Wall Street Journal that much of the concern is about counterparty risk:

Among the areas of concern: Banks’ views about how counterparties and foreign regulators would react during a crisis, and the banks’ ability to produce information they would need to achieve a quick resolution. Regulators felt that banks, in some cases, took an unrealistic approach to the potential problems regulators previously had asked them to address. These assumptions, in turn, led some firms to avoid making changes that would address those risks.

In some cases, the banks’ assumptions appeared to stem from a belief that regulators would address factors that helped exacerbate the last meltdown, such as how various countries would handle the assets of a failing global financial firm such as Lehman Brothers Holdings Inc.

Several banks presumed that foreign regulators won’t seize subsidiaries, branches or assets in their countries if the U.S. entity runs into trouble, officials said. Regulators have been negotiating with their counterparts around the world to avoid those kinds of seizures, which are known as “ring-fencing.” But until a specific agreement is in place, regulators don’t want the banks to assume money will be able to freely flow back to the U.S. parent once bankruptcy begins, officials said.

Peter Eavis wrote for The New York Times that regulators could make them sell units or take other action to comply:

If the banks do not make satisfactory changes, the regulators could take action, including requiring banks to sell units to shrink and simplify their corporate structures if they failed to comply with other orders, officials of the agencies said.

When nonfinancial companies enter bankruptcy and inflict losses on their shareholders and creditors, a panic typically does not follow. But the 2008 crisis was a chilling reminder that big banks are different.

One large bank’s troubles can prompt creditors and depositors to flee other banks, setting off chaotic chain reactions throughout the system. Confronted with such an outcome in 2008, the government chose to bail out the banks to shield the wider economy from catastrophe. Congress did not want to repeat the bailouts, so it passed the 2010 Dodd-Frank Act, which aims to strengthen the financial system.

The Financial Times reported in a story by Gina Chon and Tom Braithwaite that even the regulators aren’t on the same page about how to handle the firms:

Although they issued a joint statement, the regulators were split on their response. The FDIC took the more severe stance of deeming the plans “not credible”, a finding that paves the way for potentially punitive action. The Fed said the banks could have another chance – they must “take immediate action” to rectify the “shortcomings” or it would join the FDIC.

Both regulators must agree in order to trigger various punishments laid down in the law, including “more stringent capital, leverage, or liquidity requirements, or restrictions on the growth, activities, or operations of the company”. They can also force divestitures.

US senator Elizabeth Warren, who has pushed for a break-up of the biggest banks, recently questioned Fed chairwoman Janet Yellen on the living wills and urged regulators to use their powers to find remedies if their resolution plans were not credible.

Banks and lawyers expressed frustration at the move, complaining about a lack of feedback from regulators.

“The banks are beside themselves,” said one lawyer, who complained about the “ambush nature” of the regulatory announcement and the “non-credibility finding without an explanation”.

So, what’s next? Some in Congress are calling for the break-up of the largest banks. While it’s doubtful the government will take it that far, the banks still have to figure out a way to be in compliance with the demands to unwind in an orderly fashion. And apparently that’s not going to be easy for anyone.