On July 2, big banks must furnish a ?living will?, which would provide regulators in the US insight and understanding of the roadmap they need to follow if any of the big banks fail. Nine of the largest financial institutions must submit their living wills to the Federal Deposit Insurance Corporation and Federal Reserve. These include the top five US banks ? JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley, while the other four big non-US financial institutions are Deutsche Bank, Barclays, Credit Suisse and UBS. These nine firms have some of the biggest balance sheets, trading desks and derivatives portfolios. Smaller banks have a longer time limit to draft their plans and the due date for them is July 2013. The living wills are government-mandated contingency plans and are being undertaken because the regulators are under pressure to demonstrate that they are taking proactive actions that will make it easier for them to unwind mega banks without the use of public funds. The banks have their own incentive to cooperate with regulators or else the policymakers could seek harsher solutions. So the banking industry has publicly embraced the living wills.
We will get to know how seriously these big banks have undertaken the exercise only after the regulators have poured over the thousands of pages of documentation each of the large banks would submit. But one hopes that the exercise has been done earnestly rather than just as a regulatory requirement, in which case it would set a good precedent for the multitude of smaller banks to follow suit. The living will, although forced upon, if done prudently, provides an opportunity for banks?big and small, to undertake a comprehensive and strategic review of their corporate structure and articulate plans for reducing the possibility of extreme losses while achieving and sustaining future profitability in an increasingly complex marketplace.
That?s because the living will has a two-tiered approach. The first, ?recovery??restoring the institution to health and stability, if possible; and the second ?resolution??affecting an orderly failure, whether through sale, divestiture or other means. The recovery plan outlines the steps the bank plans to take to prevent failure and to restore capital and liquidity. This is an exercise that would be expedient for the bank when it is in an incapacitating position because it would still be able to survive on its own with little help of public funds. In the recovery plan, bank has to outline a range of actions including exiting certain segments of the banking business, selling subsidiaries, or raising additional capital. Creating the recovery plan requires analysis of these issues in advance and thus helps identify and pre-empt events that may lead to failure in the first place. Key elements of the recovery plan include ownership structure, assets, liabilities and contractual obligations; detailed descriptions of the businesses and subsidiaries that the bank might sell to third parties along with plans to deal with contingencies that might hold up these actions; identify and describe the inter-connections and inter-dependencies among large subsidiaries; demonstrate how the bank will withstand the failure of its largest counter-parties; trigger events and define what sort of circumstances would put the plan in play; and actions taken to reduce risk of a failure, in the first place.
The plan outlines how management will prepare for failure of the bank with procedures in place to manage the process in a controlled manner. The resolution plan would serve as a guide for regulators intervening in a crisis scenario in which the bank will not survive. Consequently, they illustrate an orderly process including unambiguous actions in the event the bank or part of the bank needs to be unwound. The resolution plan must identify the data that regulators will need to help them quickly segregate non-essential bank operations from elements that are systemically important and need to stay in business. This may include relationships with different legal entities within a single group, such as legal status, financial exposure, and staffing, along with contingency arrangements in case of interruption to relationship; detailed assessments of potential problems in winding down a relationship including transfer of assets and liabilities to a bridge bank or private sector purchaser or a whole bank transfer of assets and liabilities; identification of market and payment infrastructures and means of disconnecting from such systems in an orderly manner.
The recovery and resolution process, if done sincerely, has the potential to help large banks articulate the right shape and direction for the institution against some hard choices in a rapidly changing industry and market. If done from this perspective, the results could ensure tight connectivity between these plans and the overall strategy for managing the business, and strengthening and aligning communication to external markets, internal stakeholders and regulators in a more consistent and connected voice.
The temptation for many banks may be to view the living will as an unwelcome regulatory intrusion?an expensive planning exercise that produces only a set of documents that sit undisturbed on shelves or rather, in computer files ?primarily to satisfy demands of regulators. Or else, there could be harsher measures coming. Failing to plan is planning to fail, but with a living will, a plan in the event of a failure may actually operationalise a will to live.
The author, formerly with JPMorgan Chase, is CEO of Quantum Phinance
