Sunday, August 10, 2014

"Living Wills" are no answer to TBTF

The US Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) last week rejected the "living wills" submitted by 11 large financial institutions as "unrealistic or inadequately supported". The "living wills" are detailed plans, as required by the Dodd-Frank Bill, that outline how banks will dismantle their operations and financial contracts in an orderly manner in the event of impending failure. The Vice Chairman of FDIC, Thomas Hoenig said,
Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support. 
Though the Fed has asked these banks to re-submit their "wills" in an year, the revised ones are not likely to be any more useful. While logically appealing, such pre-defined resolution plans are not likely to be of much use in a crisis involving the largest banks. They are too complex to be resolved with such plans. Their complexity spans atleast three dimensions - correlatedness among atleast some of the assets held by them, interconnectedness among several institutions, and opacity in their corporate structures - all of which are amplified many times over by their massive sizes. Taken together they constitute the too-big-to-fail (TBTF) problem.

Even assuming the "living wills" bridge all information asymmetry and provide a very clear understanding of the banks' operations and its assets and liabilities, itself highly doubtful, there is no guarantee that it will enable the implementation of a resolution plan when faced with the crisis. Even if AIG had a detailed "living will" it would not have been in a position to liquidate itself without threatening to pull the entire system down. The correlatedness and interconnectedness dimensions threaten both specific markets as well as other larger firms respectively, both with potentially catastrophic consequences for the financial markets as a whole. It is therefore unlikely that regulators and policy makers will let large institutions collapse in the belief that the "living wills" and the Orderly Resolution Authority (OLA) will limit the panic from its collapse.

The orderly resolution of large financial institutions cannot be divorced from the more important issue of addressing TBTF. For example, though the "living wills" lay out the steps the banks will take to distribute its large losses among stakeholders - creditors and bond holders, and even when all those stakeholders know it well in advance, its actual enforcement will be constrained by the TBTF problem. The only way around this is addressing the complexity problem in all its three dimensions. And that in turn takes us back to more stringent macro-prudential and micro-prudential regulations. Unfortunately, the likelihood of such tough measures appears very remote. 

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