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Big banks will not die peacefully

Aug 06, 2014

Banks do a pretty poor job of imagining their own deaths.

Yesterday, the FDIC and the Federal Reserve confirmed as much when they rejected the resolution plans, or so-called "living wills," of every single one of the 11 mega-banks that submitted their plans. Other banks, like Wells Fargo, haven't received rejections just yet, but that's because the FDIC and the Fed say they haven't gotten around to it yet. So, Wells, you might as well start rewriting now.

The living wills were an odd exercise from the start. I, for one, try my best to imagine drifting off at 90 in my sleep; not, for example, burning alive trapped in a car. I have done very little to prepare for the trapped car scenario. But after making it through the financial crisis, the living wills the banks submitted come across as delusional.

JPMorgan Chase (jpm), for instance, assumes that if it were about to go under, it could sell off its businesses, for which, the bank says, there would be multiple diverse buyers, and pay back creditors. Goldman Sachs (gs), says its resolution plan rests on the assumption that the market would continue to function normally. If Goldman were going under, the market would not be functioning normally.

Do you remember the financial crisis? The only buyer of anything bank-related was the government, or another bank with government help. That's right, there was just one buyer. Us. That's why we had bailouts.

The banks didn't merely offer best-case scenarios in their living wills. They offered best, best-case scenarios.

Most reacted to the FDIC and Fed rejections by saying that this was all a waste of time. Three years ago, I reported on a simulation run at a conference by The Economist of what regulators would do, now that we lived through the financial crisis, the next time a major bank was on the brink of failure. Early on in the performance, Larry Summers, who was playing the role of Treasury Secretary—Hank Paulson's job in real life—told the other regulators to pull out the living will of the imaginary bank that was about to fail. He then told them to throw it away. It wouldn't help.

It's impossible to wind down any big bank without doing some damage to the economy. And if a big bank were to fail, it would probably happen at a time when other banks were on the brink. And so a plan detailing how to deal with the potential failure of just one bank is pretty useless. So, by that logic, living wills are useless.

But they're not. The point of living wills, or at least it should be, is not for banks to give regulators an easy and safe way to wind down a failing bank. Instead, the point is to show just how hard and painful it would be.

The problem with too big to fail banks is that lenders, because of the implied government backstop, will lend money to banks for less than they should, giving banks the incentive to borrow more and increase their risk. So why not just get rid of too big to fail? Well, that's really hard to do. The other option is to scare bondholders into thinking they are going to lose their money either way.

The government wants documents from the banks that will frighten bondholders, sending a message in big letters, "Lending to banks is risky." And they want the banks to write publicly that shortchanging bondholders and other lenders is part of their plan.

But that's not what the government got from the banks. Instead, they received bland legal documents that say that banks will figure out how to give lenders their money back. And that might happen, but the Fed was looking for stories of banks burning alive in cars and for bondholders to know they might be trapped along with them.

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