Financial reform: what banks should consider when developing “living wills"
Of all the regulatory reforms set forth, one vital step for systemically important financial firms is to develop firm-specific resolution and recovery plans, also known as "living wills." These are essentially a blueprint for winding down a troubled bank or ring-fencing the problematic parts of a firm without causing harm to retail depositors or the global financial system — and without relying on government intervention.
Given the complexity of today's financial superbanks, many questions remain over how these resolution and recovery plans would disentangle organizations in a straightforward manner. Some banks argue that living wills are almost impossible to draft without knowing the possible causes of any future crises.
Despite these concerns, in the U.S., the Dodd-Frank Wall Street Reform and Consumer Protection Act includes a provision calling for living wills for systemically important financial institutions, and in turn banks need to consider robust resolution mechanisms as a way to better manage the risks of institutional problems — at an acceptable cost — through forward planning.
For their part, regulators are eager to see large financial conglomerates write living wills, but there isn't agreement among authorities over how to proceed. Some regulators, for example, are also considering creating resolution authority groups that would be charged with the orderly liquidation or merger of failing institutions. Ideally, the authority groups would utilize the living will to facilitate this process. There is a possibility that the authorities will insist that global banks be built on a sectional framework that would make it more efficient to ring-fence, spin off or liquidate troubled parts of an institution.
Whatever shape specific oversight takes, bank boards and senior management need to demonstrate to authorities that they have highly developed plans to reduce the likelihood of problems developing into a broader contagion.
Proactive management is critical. Firms may need to consider building a governance structure and allocating senior executive accountability at an enterprise-wide level and across business lines and geographies. As governance and accountability are dependent upon good information, banks might also need to enhance their information frameworks to create a new system of analyzing and modeling potential problems.
Specific actions will vary by institution — based on business mix, company structure and operating model — but institutions should take these five steps when developing comprehensive recovery and resolution plans:
- Enter into a dialogue with the regulators and work to develop plans ahead of imposed changes to maintain business operations without interruption when the changes come to fruition.
- Create plans that are not dependent on significant fiscal support from authorities.
- Identify upfront actions that enable the firm to "de-risk" its business model. With proper planning, there may be a number of changes institutions can make that will not negatively affect the business but that will decrease risk.
- Assign a core team linked to the wider business and include input from various parts of the business. The core team should be responsible for strong and effective communications with internal and external stakeholders.
- Develop a process to maintain and update the plan annually as per the FDIC and to reflect changes in business models, transaction activity, the introduction of new products and the retirement of existing products.
Confidence in the markets will depend in no small part on how banks are managed and supervised going forward. Regulators are sending a clear message that the government safety net is shrinking, and that banks must be prepared to develop their own resolution and recovery strategies.
Failure to plan and demonstrate that a bank has mechanisms in place to satisfy required standards and milestones will be costly, resulting in higher capital requirements and other potentially debilitating problems.
The good news — for banks and their customers and counterparties — is that the banking industry realizes all of this and is moving to act.
John Liver is a London-based partner at Ernst & Young LLP.