Thursday, April 21, 2016

What's This About "Living Wills"?

Bank regulators, including the FDIC, gave failing grades to some well-known banks in the recent "living wills" test

U.S. financial regulators delivered another blow toward big banks in mid-April, 2016. Some analysts and equity markets considered it a benign one because bank stock prices hardly budged.  It provided easy fodder, however, for the bands of critics (including a presidential candidate or two) who wage arguments that big banks must be broken up.

This time the FDIC and Federal Reserve announced its list of banks that didn't pass its latest test to assure the public that tax-payer funds won't bail out the next Lehman or Bear Stearns. A slate of banks (including JPMorgan Chase, Bank of America, Wells Fargo, and State Street) failed the "Living Wills" test.

This requirement is not arbitrary or recent. Dodd-Frank, the U.S. legislation that spells out much of bank regulation after 2010, permits regulators to establish rules that require big banks (especially the ones deemed "too big too fail") to show how they will wind down their vast operations in the event of extreme distress (at or near bankruptcy) without putting us through what the globe endured in 2008.

In other words, if a bank like JPMorgan or Wells Fargo in control of over $2 trillion in assets in all parts of the globe is in jeopardy of going out of business (perhaps because of mounting loan losses, extraordinary asset concentration, gigantic trading losses, insufficient capital, or fraud), can it manage an orderly liquidation of the business? Can it do it without hurting depositors and causing wreckage in capital markets?

And can it do so without the U.S. Government having to intervene? Can it do it without the Government feeling obliged to inject new capital to keep markets at peace and avoid jeopardizing the existence of the financial system? Can that orderly process occur with only shareholders (and maybe subordinated debt-holders) bearing the inevitable billions in losses?

In 2015, regulators requested banks to complete this  exercise.  After assessing the "living wills," they would decide which banks passed or failed--regardless of how well those banks are performing today or how well the banks meet current regulatory requirements for capital, leverage and liquidity.

The banks got their report cards recently, and they accepted their wrist slaps in stride, suffered a little embarrassment and promised to redesign their respective liquidation plans.  They must present improved presentations of  "living wills," and they are taking this seriously.

Why did JPMorgan, a bank cushioned with over $200 billion in book capital, fail this test?

How could the big behemoth, with $20 billion-plus annual profits and with its hands entangled in about every form of financial transaction that exists, have not passed?  JPMorgan management is blaming technicalities.  And it might have a case (although that won't convince regulators to change their grade).

Regulators examined a hypothetical scenario where the bank's credit ratings have been downgraded to near-default status (or the ratings have been withdrawn) and where the bank's parent company is in or on the verge of bankruptcy. They argued a JPMorgan liquidation process, as catastrophic as that seems, has short falls that require immediate attention. The bank has the rest of this year to redo the will. A catastrophic-sounding wind down, regulators insist, must have minimal impact on the rest of the financial system.

In reality, if JPMorgan is about to implode and if rumors of bankruptcy abound and even if its problems and woes are isolated, it's likely other big institutions will be fumbling (or failing) because of similar issues.  Big banks have similar businesses,  strategies, balance-sheet content, and ways of managing risks. They often interface, compete, or aggressively manage markets in similar ways. Paraphrased, they often copy each other, if only to compete and grow. If JPMorgan is going down, then it's likely Goldman Sachs and Citi are suffering similar financial anxiety.

The goal of a "living will" is to ensure an orderly, safe liquidation that follows a regulatory-approved "playbook."  The implied goal is to assure all of us the financial system won't suffer a repeat of 2008.

Explaining in clear communication, regulators directed JPMorgan to clean up lingering issues with liquidity management, complex legal structures, and derivatives exposures.  To their credit, they outlined the problems in layman's detail.

Bank overseers say the bank's liquidity plan has weaknesses.  The bank has vast amounts of cash reserves (to meet short-term obligations), but the bank is over confident its ability to summon up cash that might be trapped in subsidiaries, particularly regulated entities.  Regulators want the bank to assume that parent cash deposited at a major subsidiary might become "ring-fenced," trapped overseas, blocked by other rule-makers or encumbered by third parties, unable to be funneled back to the parent.

They also remark the bank's parent entity presides over a sometimes inexplicably complex legal structure, one that would with certainly impede an orderly liquidation. They recommend the bank consider aligning legal entities with business activities.  No doubt regulators are aware big financial institutions create hundreds of legal entities, often to separate regulated activity from non-regulated activity, sometimes to extract exotic, difficult-to-value assets from trading units that seek a high-grade credit rating.

Regulators also want to see a better plan for recapitalizing some of those entities, if and when necessary. And they are pushing for a stronger outline for how it would wind down billions in derivatives exposures.

The strikes above result partly from the bank's size (cash reserves residing on balance sheets around the world, vast numbers of unexplained legal entities, and exposures in nearly every kind of derivative that is traded).  That explains why it can be harder for JPMorgan to pass a "living will" test than it would be for a   domestic, medium-size bank, even one that isn't growing or is barely profitable.

However, it's a strike, and it's a new era. The bank's legal staff, compliance officers and financial managers will hastily respond and resubmit a stronger liquidation plan, even if the probability of a such a bankruptcy is low and unimaginable.

Tracy Williams

See also:

CFN:  Banks and their Energy Loans and Losses, 2013
CFN:  JPMorgan's Regulatory Rant, 2012
CFN: Credit Suisse Makes a Big Move, 2015

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