Forcing banks to draw up their own death plans—an exercise in futility?

Dismantling banks is hard work!
Dismantling banks is hard work!
Image: Reuters/Harry Suhartono
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Breaking up is eminently hard to do.

The Federal Deposit Insurance Corp. and Federal Reserve announced yesterday that they had finished their reviews of the “living wills” filed by 11 large US banks, intended to give regulators a blueprint for unwinding the institutions in a failure scenario. They found the submissions seriously wanting.

It makes sense that regulators need a window into how they might achieve an emergency dismantling of these sprawling financial institutions, with assets in the trillions of dollars and business units peppered all over the world. An orderly wind-down should always be preferable to a government bailout, but regulators need confidence in the first option to rule out the second one when a gargantuan bank is on the brink of collapse.

Critics of the living will exercise argue that constructing a death plan for banking giants may be a fool’s errand. That’s because it’s not easy to predict how bank executives, clients, counterparties, and even regulators would react in the event of a full-blown crisis.

Sanford Bernstein bank analyst Brad Hintz tells Quartz that painting dire scenarios on paper can be starkly different than the reality. “With any larger financial institution you’re always going to end up with unknown, unknowns,” says Hintz, who formerly worked at Lehman Brothers as its chief financial officer and at Morgan Stanley as treasurer.

There might even be scenarios in which having a bank (or banks) adhere to a living will has the opposite effect of injecting calm into a terror-ridden market. Regulators might conclude that they have to keep an institution alive, regardless of whether an end-of-life directive exists.

“You have to role play these scenarios as a regulator at the Fed or the Treasury. If the world is coming to an end, you’re going to have to invoke your best Dirty Harry and ask yourself if you’re feeling lucky today,” Hintz quips, referring to the hard-charging police inspector played by Clint Eastwood.

In some ways, the challenge of constructing a living will gives credence to the argument that some institutions may simply be too big to fail and should be broken up. Indeed, regulators already have threatened to invoke their break-up power if the big banks that failed the first round of reviews don’t deliver on their next attempt in July 2015. But coming up with a credible plan, as regulators have charged the banks to do, may be an unrealistic goal given the complexities of the firms.

FBR Capital markets bank analyst Paul Miller perhaps put it best for the Wall Street Journal (paywall): ”To sit there and try to come up with a plan to try to orderly unwind a major institution of this size, I don’t know if it can be done.”

But regulators seem to have embraced the crisis-management maxim espoused by former Treasury Secretary Tim Geithner in his book Stress Test: “plan beats no plan.”