When banks lose the will to live

So too in banking. No one wants to talk about banks dying, euphemisms abound. Yet allowing them to die properly – and in this case that means with minimal disruption to financial systems – is at the centre of the regulatory agenda kicked off by the financial crisis in 2008.

The notion of institutions being too big to fail is all about economies being squashed when financial elephants keel over.

For all the technical debate around risk weighted assets, leverage ratios and liquidity, there is little theoretical dispute regulators – and particularly governments – should interfere as little as possible if institutions are terminally ill. As long as the system is safe.

Death is at least obliquely referenced in the regulatory concept of “living wills”. Much work has been done on this so-called recovery and resolution planning. Recovery plans are about intensive care when something goes wrong; resolution is about palliative care and distributing assets among the living when nothing more can be done.

Regulators and supervisors around the world, under the auspices of Basel-based Financial Stability Board, have been working on these plans for some years now and are at quite different stages.

Last week US regulators, operating under their 2010 Dodd-Frank Act, heavily criticised the resolution plans several systemically important banks – those which are considered too big to fail – had submitted.

Five major US banks were told to substantially revise their wills by October 1 or face potential sanctions.

The banks, JP Morgan Chase & Co, Wells Fargo & Co, Bank of America Corp., Bank of New York Mellon Corp and State Street Corp were told by the two lead regulators, the Federal Reserve and the Federal Deposit Insurance Corp, their plans didn’t meet the standards of Dodd-Frank if they faced bankruptcy. The regulators were split on two other banks, Goldman Sachs Group and Morgan Stanley. Citigroup passed with some reservations.

The key requirement for a resolution plan is a credible scheme for bankruptcy to proceed at no cost to taxpayers. Sanctions might include many of the other strategies regulators are adopting to make the system safer such as more capital or restrictions on operations.

Each jurisdiction is different however, acting under different laws, and there is some debate about whether Australian regulators would have the same resolution powers. Although neither the Australian Prudential Regulation Authority or the Reserve Bank have commented recently on living wills, it is understood the emphasis with banks to date has been on recovery rather than resolution.

The Murray Financial System Inquiry argued Australia had weaker resolution regimes. With Australian recovery plans, drafts have already been provided in recent years but it seems APRA is looking for updated plans, taking in regulatory developments, by the end of May. Reading between the lines of recent APRA communications suggests recovery planning will be a focus this year.

While there are many moving parts in the regulatory puzzle at the moment, the narrative theme is that measures on capital, leverage and liquidity are aimed at making the system more robust and hence pushing out the boundary for when formal recovery is necessary.

Moreover, these extra elements should make recovery easier. And if recovery fails, the system should be able to cope with the grief.

Another complicating issue however is the components of these reinforcement measures, particularly what is known as Total Loss Absorbing Capital (TLAC). TLAC will form the foundation of the capital base but there is still debate around what will qualify as TLAC. Equity definitely will. Some hybrid debt which converts to equity may not. And there’s an almost endless spectrum in between.

In Australia, for example, there has been robust debate about what powers APRA already has to commandeer what was considered straightforward debt to recapitalise banks.

Moreover , new debt instruments, known as contingent convertible capital instruments (CoCos), are also entering the market and investors are still gauging where they should rank in the risk (and hence price) hierarchy of bank funding structures.

The proximate issue though is even while this uncertainty prevails – and there is no indication it will be settled in the short term – capital markets remain open, banks have a need to raise funding and investors are pushed to deploy cash, particularly in a world of near zero interest rates.

In such a situation, investors are demanding higher yields to compensate for the risk of uncertainty. According to market insiders, that has seen several debt and hybrid issues put on hold. Added pressure comes from investors who build their criteria around exit strategies – when it is unclear whether regulators will actually let them exit (and not convert their debt to equity) they stay on the sidelines.

There are two broad forces at play then in the new era of regulation. The first is what is necessary to create sufficiently safe institutions – that is capital, leverage and liquidity. The other is preparation for when even those more robust measures are not enough and a bank fails.

Critically, it must remain possible for banks to fail. Economies simply do not function optimally if banks are either too safe – which would restrict risk financing and hence innovation and new company creation (or too big to fail) – which leaves taxpayers on the hook for resolutions the system should be able to handle.

Living wills are destined to stay in the headlines this year.

As that great banking analyst Nick Cave wrote, death is not the end (in banking):

When the storm clouds gather round you/And heavy rains descend/Just remember that death is not the end /And there's no-one there to comfort you/With a helping hand to lend/Just remember that death is not the end