Raising the bar on living wills

Last month the Federal Reserve Board and FDIC released a joint statement saying that the agencies had “identified specific shortcomings” in the “living wills” submissions of the Wave 1 banks “that will need to be addressed in the 2015 submissions.” The agencies separately provided letters to the 11 banks that had submitted their second plans in October 2013 detailing the shortcomings in each institution’s plan and the agencies’ expectations for the 2015 submissions.

Although the demand for more details and concrete plans to enhance the firms’ resolvability was not entirely unexpected, the requirements outlined for 2015 and the potential implications for missing the mark should make all banks—regardless of size and complexity—take note. Through their joint statement and other comments, the Fed and FDIC have made it clear that failure to develop a credible resolution plan will have consequences that could ultimately even include forced restructurings, regardless of whether there was a current crisis.

How industry got here

There are a number of steps banks can take to satisfy both the letter and the spirit of the Dodd-Frank-mandated resolution plans, or “living wills,” but it is instructive to briefly review how we got to where we are today.

The current situation is, of course, directly related to the lessons learned from the 2008 financial crisis. The crisis revealed that the banking industry was more interconnected than previously thought, which means there is greater potential for contagion if a major institution were to fail. While large banks operate globally, they fail locally and regulators are more attuned to the local impact of failure than ever before.

Thus, resolution planning has become a foundational capability required of large, complex financial institutions.

By definition, as the Fed and FDIC noted, a resolution plan must describe the company's strategy for rapid and orderly resolution in the event of material financial distress or failure of the company.  Resolution planning is an important component of banks’ expanded capabilities to envision stresses and prepare in advance for those events. 

What agencies’ response means

Statements by FDIC Board members indicate that they believe each of the 11 “Wave 1” banks’ 2013 plans was “deficient and fail[ed] to convincingly demonstrate how, in failure, any one of these firms could overcome obstacles to entering bankruptcy without precipitating a financial crisis.”

While bank-specific feedback was not released by the agencies, their broad-gauged public message has officially put everyone on notice that generally more concrete structural and operational actions must be taken to improve the largest banks’ resolvability.

If, in the eyes of the regulators, appropriate improvements—or sufficient progress towards them—are not made by 2015, the Fed and FDIC could determine that the resolution plan is not “credible” or would not facilitate an orderly resolution through bankruptcy.

A “not credible” finding would mean that, under the applicable law and implementing regulations, the bank would have 90 days to address deficiencies. If the resubmitted plan were still to come up short, the regulators would have the authority to impose more stringent capital, leverage, or liquidity requirements, or restrictions on growth, activities, or operations, leading to the potential for the Fed and FDIC ultimately to jointly direct the bank to divest assets or operations if the deficiencies are not satisfactorily addressed within a two-year period.

Meeting 2015 requirements

Based on the public feedback to Wave 1 banks, the guidance to Wave 2 banks earlier this year, and the recent guidance to Wave 3 banks, the Fed’s and FDIC’s focus for improvements centers on five areas:

1. Structural reform. Banks will be required to simplify their legal structures and operate with fewer subsidiaries.

There will be an increased use of local, standalone legal entities rather than branches of a parent company. These entities must have their own capital, liquidity, governance, and management information systems. Finally, financial resources must be positioned to allow sufficient time to survive a severe stress environment or to provide adequate funding to support an orderly wind-down.

2. Operational continuity. Institutions must demonstrate the ability to let individual legal entities fail while continuing and operating other entities, particularly those where critical operations reside.

Critical services and resources, such as key personnel, systems, and data management, must be maintained to support required operations. While there is no prescriptive path for ensuring continuity of critical operations, there are limited ways to accomplish this, such as removing resources necessary to support critical activities from the operating companies and establishing separate, dedicated service companies. 

3. Crisis data reporting and availability. Firms should have robust management information systems.

These systems should be able to produce and maintain financial, operational, and contractual data at a legal entity level and can support decision making for all parties leading up to, and at the time of, potential failure. Data should be readily available to enable continuing operations during a crisis.

4. Financial contracts modifications. To limit potential contagion, regulators are asking banks to remove cross-default clauses from qualifying financial contracts.

One such example is International Swaps and Derivatives Association (ISDA) agreements for derivatives. Modifying these contracts will entail a significant effort for banks, including working with industry groups, such as ISDA, and with individual counterparties for bilateral contracts.

5. Relationships with third parties. These include customers, counterparties, investors, financial market utilities, and regulators.

Institutions must develop a greater understanding of their interconnectivity with third parties, including connections with financial market utilities (FMUs), and their processes for maintaining access to critical FMUs during a crisis. Contingency plans and operational capabilities need to be demonstrated for addressing the potential range of actions third parties may take and the actions that the bank will need to take in response. This will require banks to improve a number of existing capabilities. (Among FMUs identified thus far are the Chicago Mercantile Exchange and Depository Trust Co.)

Assumptions used in resolution plans related to third parties and their likely behavior in a crisis should be reevaluated, and banks will need to develop plans and model stress scenarios through the lens of these revised assumptions.

For example, many banks will need to strengthen their collateral management practices to achieve a clearer understanding of who holds collateral, to whom it is pledged, and where it is held at all times.

Looking ahead

This first round of specific feedback on Wave 1 bank resolution plans has put all banks on notice—particularly those with $50 billion or more of total consolidated assets that are required to file resolution plans—that more work needs to be done to build out firms’ core resolution planning capabilities.

Now, more than ever, institutions must simultaneously manage a multitude of “change-the-bank” initiatives that permeate every part of their organization, including initiatives to better enable resolvability. While the regulators have identified their areas of focus, it will be up to each institution to define its own resolvability model.

Institutions below the $50 billion threshold will need to take into consideration the five areas mentioned to the extent that they plan to merge or organically grow into a significantly larger institution in the foreseeable future.

About the authors

Brian Boyle is principal of financial services at Ernst & Young, and Daniel Scrafford is senior manager of financial services at the firm. This article is for general informational purposes only and is not intended to be relied upon as professional advice. Please refer to your advisors for specific advice.