Living wills aren’t for humans only. The Dodd-Frank Act requires large financial firms, those called “too-big-to-fail,” to prepare “living wills” detailing how they could be resolved under the Bankruptcy Code without threatening the rest of the financial system or requiring government assistance.
The Federal Reserve Bank of Richmond’s August Economic Brief explores the benefits and challenges of developing credible living wills—resolution plans for systemically important financial institutions, known as SIFIs. The Brief states that living wills should help regulators make SIFIs resolvable through bankruptcy with minimal disruption to the economy as a whole. However, regulators face significant challenges in making these large and complex financial institutions resolvable.
Background. The
Dodd-Frank Act requires each SIFI to create a plan that a bankruptcy court
could follow if the institution fell into severe financial distress. The plan
must set out a path for resolution without public bailouts and with minimal disruption
to the financial system.
However, if the Federal Reserve Board and the Federal
Deposit Insurance Corporation find that the best feasible plan does not set out
a credible path to resolving the firm without public support, they have the
power to require the firm to increase its capital or liquidity, limit its
growth, activities, or operations, and even divest assets to make such
resolution a credible option in the future.
Regulators’
challenges. Although living wills can help to curb the “too big to fail”
problem, regulators face a number of challenges in achieving this goal. In
“Living Wills for Systemically Important Financial Institutions: Some ExpectedBenefits and Challenges,” authors Arantxa Jarque and David A. Price consider
the challenges confronted by regulators who must oversee the transition of
SIFIs to resolvability, and some possible approaches to managing them.
Short-term financing.
One of the challenges facing policymakers is that SIFIs in their present form
have large liquidity needs. In the event of distress, finding interim funding
may be important to minimize losses and market disruption. Therefore, the authors
state, regulators assessing a living will should consider who could
realistically provide the funding.
The question is, according to the authors, would a failing
SIFI, given the short-term financing needs that its size and structure imply,
be able to obtain sufficient financing to see it through the bankruptcy
process? If not, authorities may feel compelled to provide emergency financing,
“effectively providing a bailout and encouraging moral hazard.”
To maintain a credible commitment not to provide financing—that
is, not to rescue the firm—policymakers may need to limit the reliance of some
SIFIs on maturity mismatch (for example, accepting deposits that can be
withdrawn on demand and using them to fund long-term loans). The authors
believe that once policymakers have established a credible commitment not to
rescue firms in distress, “the lack of a safety net would cause the price of
debt to become more sensitive to the amount of maturity transformation, leading
SIFIs to restrain their reliance on short-term funding and reducing the need
for short-term financing.”
Organizational
complexity. Another potential obstacle to making institutions resolvable is
that they may have highly complex structures. The authors found the challenge
here to be the difficulty faced by regulators in untangling relationships and
determining which parts are most important to the stability of the overall
financial system and could be taken over by another institution.
However, the authors point out that the Dodd-Frank Act gives
regulators the power to require SIFIs to reduce their complexity. Also, market
forces could prove helpful, the authors stated. Once regulators have
established the credibility of their commitment not to rescue, the authors
believe that debt holders would “have an incentive to monitor institutions for
excessive complexity that might reduce their ability to recover their money in
a bankruptcy proceeding.”
Cross-border issues.
One aspect of the complexity of systemically important institutions is that
they often operate across numerous national boundaries. The authors note that
while supervision of global institutions “is an everyday event in which
cross-border matters are dealt with routinely,” resolution of the institutions
is a rarity, leaving room for uncertainty about what a cross-border resolution
would look like.
The authors fear the possibility that multiple proceedings
may be problematic due to inconsistent legal regimes in different countries or
difficulties in learning about an institution’s foreign-based operations. Part
of the answer to these concerns may be found in “country level
separability”—making sure the local operations of an institution are resolvable
independently of its foreign-based entities.
The more self-contained and self-supporting an institution’s
operations within a country become, the authors contend, the less that
cross-border issues will reduce the value of the firm in resolution and the
more credibly regulators can commit to a no-bailout policy.
Transparency.
Even if SIFIs achieve financing structures and organizational structures that
make them resolvable, the authors write, this outcome will not lead to market
discipline if market participants do not believe that resolvability has
happened. This becomes another challenge for regulators: deciding whether
markets will accept the agencies’ own determinations about resolvability, or
whether markets will need to see some of the underlying facts for themselves.
Regulators need to decide how much transparency in living wills is desirable.
A conflict can arise between maintaining the confidentiality
of proprietary information and the public’s legitimate interest in assessing
whether a firm’s ability to be resolved without assistance has been achieved.
The authors said, “The right level of public transparency for living wills is
an open question.”
Summary. The
authors summarized by stating that challenges posed by short-term financing
needs, organizational complexity, and cross-border issues may require
regulators to use the enhanced authority granted to them by the Dodd-Frank Act
to impose changes in firm structure that ensure resolvability. However, market
forces should eventually push firms toward such changes, as well—once the
financial system understands that the living wills process significantly
decreases the probability of bailouts. And, sufficient “transparency in the
living wills process is key to achieving this outcome.”
