Capital Markets Advisors

The news this summer that the banking regulators had rejected the living wills of the 11 largest banks has caused considerable consternation, not just in those banks, but in astute observers of the financial markets. Thus it is appropriate to examine the whole question of the orderly winding down of large banks.

The Plans and the Response

The living wills rejected last month were the second round submitted by these banks. In its rejection, the Fed highlighted as common shortcomings:

“The use of optimistic and unrealistic assumptions about the ability of the firm to avoid the consequences of bankruptcy, reliance on unsupported expectations regarding the international resolution process, and failures to address structural and organizational impediments to an orderly resolution of the firm in bankruptcy.”

In addition, the regulators called for these specific improvements:

• 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 [Note: This refers specifically to ISDA Master Agreement paragraph 2(a)(iii), as discussed here.];
• 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.

In order to assess whether these wills, or any future versions, have any value, we have to understand something about monetary economics.

Monetary Economics 101

The first thing we need to understand here is that banks are unique in the economic sphere because what everyone else thinks of as an asset they think of as a liability. In other words, in the modern economy, money is almost exclusively made up of one bank or another’s promise to pay. I pay for things, and you do, and the largest companies in the world do, by exchanging a bank’s promise to pay. My bank account (and yours) is actually comprised of a bank’s promise to pay.

When we get to the stage where essentially all money is made up of a promise to pay, the entire worldwide economic system is dependent on everyone’s acceptance of that promise. Thus, even the inkling that some bank’s promise is suspect will cause a predictable wave of events, as holders of that particular promise attempt to exchange it for a better quality promise. Even in the days of Adam Smith, this was well known enough to spawn the maxim, “Bad money drives out the good.”

Long ago, the frailty of the promise-to-pay form of money was recognized, and it led to the creation of deposit insurance and the resulting regulation of the banking sector. However, two developments have changed the world since deposit insurance came into existence at the beginning of the 20th century. The first is universal banking, where the deposit franchise has been merged with trading and underwriting. The second is the growth of the uninsured segment of the deposit universe. Taken together, they have significantly increased the risk of the modern version of a bank run.

Resolution in the Modern World

This understanding of monetary economics sheds new light on the question of resolving a failed bank, better known as a living will. The first component of that understanding is seeing that, in this case, perception is reality. It doesn’t actually matter whether a bank is solvent or not – what matters is whether the economy as a whole thinks it is solvent. As long as there are no doubts about the quality of a bank’s promise to pay, everything is fine, no matter how much capital it has or whether its living will is up to snuff. Once a critical mass of market participants begin to doubt the promise to pay, it doesn’t matter if the bank has 20% Tier 1 capital, the rush is on to get out of that institution, and its living will is of little use.

So the foremost concern for banking regulators has to be perception. The way they ensure perception, though, is through reality. That is why the regulators have been very reticent to release the results of stress tests if they think they will affect perception. And it’s why the regulators are reticent to release the current living will documents. But there is a reality that the regulators, and the public, need to be aware of.

[Related: “DOA: Living Wills and Liquidity – Lessons for Traders and Investors” (Quant FORUM)]

As we learned in the recent banking crisis, financial risks have a long tail. Policy mistakes made in the 1990s and lending mistakes made in the early 2000s resulted in the crisis of 2008-09. By the time the cracks in the financial foundation started to show, the basement was already full of water and the house was sliding down the hill. Radical actions by the regulators and Congress were all that saved us from a full-blown implosion.

A Quick Look Forward

So what could cause another financial panic? If history is any guide, it would be the financial failure of a non-bank, which puts the viability of one or more banks in question. As people rush to see who is exposed to the failure, some will act out of fear instead of knowledge, so the panic would spread from the truly impaired to those only marginally involved. At that point, the global regulators would have to step in and backstop all the banks.

And where could that all start? Where is there the most risk housed in the least-regulated entities? It’s the newest sector of the market, clearinghouses for derivatives. What’s important to note about these entities is that they are billed as reducers of risk, but they are among the least-regulated of financial institutions. How much capital do they have? You don’t know? Hmmm.

[Related: “Derivative Clearing Houses Shouldn’t Be Too Big to Fail, Either”]

And they harbor a significant moral hazard as well. In the bilateral derivatives world, each firm does due diligence on every counterparty. In the cleared world, you’ll do business with anyone, as long as the trade clears. Unfortunately, both the CCP and the FCM are in a competitive arena, where risk aversion doesn’t play very well, so due diligence may suffer as a result.

In such a scenario, panic can spread very quickly, particularly if people can’t withdraw their cash from a CCP or FCM. Uncertainty in this case is worse than knowing the truth, and perception rapidly becomes reality. In that situation, nobody will care or remember which bank had a viable living will and which didn’t. If living wills prompt regulators to take a harder look at where risk resides in the market, and how interconnectedness works in a panic, they will have some value to us all. If not, they aren’t worth the paper they are printed on.