The FDIC and Federal Reserve Board on August 4 issued a stunning rejection of the living wills submitted by 11 major US and foreign financial institutions (JPMorgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup, Deutsche Bank, Barclays, Credit Suisse, UBS, State Street and Bank of New York Mellon) that were required pursuant to Section 154(d) of the Dodd-Frank Act. According to the joint press release issued by the agencies, rejection of the plans was based upon several common shortcomings:

(i) assumptions that the agencies regard as unrealistic or inadequately supported, such as assumptions about the likely behaviour of customers, counterparties, investors, central clearing facilities, and regulators, and

(ii) the failure 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.

The FDIC found that the plans were “not credible or would not facilitate an orderly bankruptcy process, whereas the Federal Reserve, in a separate statement, found only that the organizations must make meaningful improvements in their plans. The statute requires that if both agencies find the plans not credible, then this would require the agencies to issue a notice of deficiency, would trigger resubmission requirements, and might even be accompanied by a strong supervisory response. Instead, the agencies gave the institutions until next July of 2015 to make adjustments to their plans and organizational structures to facilitate their resolution under the bankruptcy code. The adjustments are to include:

• 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.

This is now the third year that some institutions have been required to submit plans. The inability of either the regulators or institutions to narrow the gap between the plans and what regulators and the law require has to be frustrating to both the institutions and regulators. The institutions are frustrated by the lack of guidance and feedback necessary from the regulators as to what is required. The regulators are in turn frustrated by the complexities implicit in the statute they are required to implement.

[…]

In banking, the problem goes back to the 1950s and gave rise to the Bank Merger Act of 1960 and the Bank Holding Company Acts of 1956 and 1970. If banking institutions were regarded then as being so complex as to require prior approval of mergers because of the problem of disassembling them if a merger was found to violate the antitrust laws, they are infinitely more complex now. The problem faced by regulators and institutions today is more like unscrambling an omelet made not only from eggs but also mushrooms, onions, peppers, ham, etc. Picking the omelet neatly apart while preserving the integrity of the essential ingredients is simply not feasible.

So what are the regulators and institutions to do? There are two extremes; exploring these constitutes a thought experiment that provides insights as to the issues that must be resolved when regulators evaluate proposed alternatives.

At one extreme, regulators could limit financial holding companies (which all the major SIFIs are) to passive ownership of shares in independent units that have been designated as engaging in what has been deemed to be permissible activities. Each unit would be required to be totally self-sufficient and would be prohibited from sharing resources, common management, liquidity management oversight, cross-guarantees, etc.

[…]

At the other extreme, the regulators could force institutions to abandon the holding company organizational form and to operate instead as a single corporate entity with branches but no subsidiaries or affiliates.

[…]

Of course, the likelihood of either of these extreme approaches being adopted is nil. But then, working from those extremes, the issue becomes, which of the restrictions should be relaxed while limiting the potential for systemic risk? For example, would a bank holding company be permitted to establish an operations subsidiary to provide computer processing and related account-servicing activities? If so, then the threshold question would be whether an affiliate using such services could easily replace the services provided should the service entity fail. Should a holding company be permitted to provide consolidated risk management and liquidity services? If so, could that activity be wound down, and how would losses be apportioned? In the case of the single-entity firm, the question of what activities would be permitted and what degree of complexity would evolve would ultimately depend more on management and the internal monitoring and governance incentives created by incentive and bonus restrictions than on regulatory fiat.

The point here is that analyzing the key issues from a set of polar options may be a more productive and fruitful way of identifying and segmenting the tolerable risks and key issues, as opposed to starting from the status quo and trying to unscramble the egg, which is likely to be a fool’s errand.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.

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