Five years after Dodd Frank, SIFIs still haven’t drafted credible living wills.
The Federal Reserve and the Federal Deposit Insurance Corporation announced on August 5 that the 11 banks dubbed systematically important financial institutions (SIFIs) had failed to provide credible resolution plans. Firms with more than $50 billion in assets were required to draft these so-called “living wills” in order to facilitate their unwinding should another crisis of the sort that hit Wall Street, and in particular, Lehman Brothers, in 2008.
One of the main problems with this for treasury is the confusion over SIFIs’ counterparty status in the event of a disorderly meltdown. This was one of the more difficult issues when Lehman Brothers failed in 2008. Essentially, banks have untold numbers of legal entities – some set up as counterparties for specific transactions – and how each of these will be identified and managed in the event of a bankruptcy is anyone’s guess.
Senator Elizabeth Warren gave a sense of the scope of the issue while questioning Fed Chair Janet Yellen last month. Warren said that at the time of its bankruptcy, Lehman had $639 billion in assets and 209 subsidiaries; today, JPMorgan has nearly $2.5 trillion in assets and 3,391 subsidiaries.
The legal entity counterparty issue is not insurmountable. In fact, it is a SIFI microcosm of the broader reference entity problem addressed by the financial services industry around 2000. Prior to that, derivatives confirmations could have any number of reference entity irregularities – one might say General Motors, another GM, and so on. Dealers led by Goldman Sachs established reference entity database that everyone could use to eliminate the legal headaches that could arise from these irregularities.
But despite sorting this out for the broader market, banks failed to change their internal processes. The living wills are meant to address this (among many other things) by specifying how each legal entity will be handled – or at least specifying a process that regulators would feel is adequate. And, while regulators began telling banks to start rationalizing their legal entities five years ago after Dodd Frank passed, little progress on this front is apparent.
This is a problem because regulators hoped that the legal entity issue would partly resolve itself as the transactions in question rolled off, matured, were compressed or torn up over the course of five years. The hope was that new transactions would be handled via master legal entities, or at least more rational ones, and so the legal confusion would decline over time.
There has been some clarification in the last two years due to market structure and bank business model changes. First, the need for banks to slash their assets to improve their capital ratios has had the effect of reducing the potential for counterparty confusion in the event of a bankruptcy. Second, the requirement for standardized derivatives to trade through swap execution facilities and be centrally cleared has reduced the notional amount of new derivatives being bilaterally originated. More corporates, meanwhile, are now dealing with clearinghouses where there is no counterparty ambiguity. Third, the Volcker Rule, which comes fully into effect next year, is reducing the number of legal entities devoted to proprietary trading.
Rap on the Knuckles
FDIC and the Fed were scathing in their assessments of the resolution plans put forward by the 11 so-called first filers. They said: “Based on the review of the 2013 plans, the FDIC Board of Directors determined pursuant to section 165(d) of the Dodd-Frank Act that the plans submitted by the first-wave filers are not credible and do not facilitate an orderly resolution under the U.S. Bankruptcy Code. The Federal Reserve Board determined that the 11 banking organizations must take immediate action to improve their resolvability and reflect those improvements in their 2015 plans.”
In a release, the Fed and FDIC said the plans had certain common problems. First, they relied on assumptions that the agencies regard as unrealistic or inadequately supported, such as assumptions about the likely behavior of customers, counterparties, investors, central clearing facilities, and regulators. Second, the SIFIs failed 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.
Specific criticisms were delivered to each of the 11 SIFIs but were not made public. The banks have until July 1 of next year to fix the problems and come up with plans that address the regulators’ main requirements. These are:
- establishing a rational and less complex legal structure that would take into account the best alignment of legal entities and business lines to improve the firm’s resolvability;developing a holding company structure that supports resolvability;
- amending, on an industry-wide and firm-specific basis, financial contracts to provide for a stay of certain early termination rights of external counterparties triggered by insolvency proceedings;
- ensuring the continuity of shared services that support critical operations and core business lines throughout the resolution process; and
- demonstrating operational capabilities for resolution preparedness, such as the ability to produce reliable information in a timely manner.
Former FDIC chair Sheila Bair wrote an editorial in the Financial Times shortly after the announcement, praising the regulators for finally stating the obvious. But she took the Fed to task for dousing “the message with cold water, expressing legalistic reasons why it did not plan to be too tough.” Bair asked, “…do regulators want to end bailouts or not? I fear that many of them still quietly subscribe to the view that bailouts are inevitable.” The FDIC and the Fed have, at least, taken a first step in revealing the extent of the problem to the public.