Financial Planning > Behavioral Finance

‘Living Wills’ Expose Banks’ Fragility, but Won’t Forestall Disaster

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Sunday marks the deadline for the largest banks with operations in the U.S. to submit so-called “living wills” to regulators who under Dodd-Frank have unprecedented new powers to unwind banks in the event a new financial crisis triggers defaults.

The “living will” documents, expected to number many thousands of pages, will enable the Federal Reserve and the FDIC to jointly supervise and disentangle if need be “systemically important” banks, either through bankruptcy or the forced sale of subsidiaries. The Sunday deadline applies to the five largest U.S. banks and to four foreign banks with a significant U.S. presence.

Simon JohnsonSimon Johnson (left), an MIT professor and member of the FDIC’s Systemic Resolution Advisory Committee, in an interview with AdvisorOne, gave the living wills a mixed review.

“Living wills play an important role going forward because they force the banks to lay out how they can be liquidated,” he said. “But will we ever be able to use a living will to shut down a bank? I’m skeptical.”

Johnson also endorses Sen. Sherrod Brown’s (D-OH) Safe Banking Act, which supporters say would shrink the largest U.S. banks to a size that would not jeopardize the health of the financial sector or U.S. economy more generally.

“I favor making the country’s banks small enough and simple enough so that nobody is too big to fail,” he says.

But neither living wills nor Brown’s legislation, which would take a long time to become law if it ever gets that far, matches the urgency of forestalling the imminent danger posed by banks, Johnson says.

Johnson, the co-author of two popular books that critique the ways of both Wall Street and Washington, worries that “when the history of [the current financial crisis] is written, 2008 will look like the precursor to the big crisis in Europe, which will spread to the rest of the world.”

And, according to Johnson, the living wills reveal just how fragile our current banking system is. In a recent Bloomberg View op-ed, Johnson noted that JPMorgan Chase & Co.’s own analysis shows it would take a mere $50 billion to bring down the bank—the country’s largest, with a multi-trillion-dollar balance sheet.

The initial catastrophic loss-causing event would “trigger a run on the bank—not a retail run, but a wholesale run,” Johnson told AdvisorOne. “People who provide funding to JPMorgan on an overnight basis…would withdraw that funding,” with knock-on effects totaling $200 billion in losses and $550 billion in liquidity outflows.

An event of that kind is entirely foreseeable, Johnson says, pointing to the possible breakup of the euro, however it materializes, as an obvious trigger. “That transition will be disorderly, and that’s the real danger here.”

While it’s anyone’s guess when the next potential crisis will occur—the power and credibility of the European Central Bank may enable it to avert crisis for months or years—a shock can also come quite suddenly, Johnson says.

For that reason, Johnson calls for immediate actions to strengthen vulnerable U.S. financial institutions by barring banks from distributing dividends and buying back shares. “There is no downside to this at all,” Johnson says, adding that the resulting increase in equity would provide a buffer against losses and protect taxpayers.

He also cited approvingly investor Michael Price’s idea of breaking up banking conglomerates to unlock greater value for shareholders. “How long are the boards of directors going to stand by and take no action and let [bank stocks] be pounded?” Price told Bloomberg.

However it’s done, defanging the large banks has got to be done effectively and soon to forestall economic disaster and to protect taxpayers, he says. Noting the role Fannie Mae and Freddie Mac played in bringing on the 2007-2008 financial crisis, Johnson asks: “Who are the GSEs [government–sponsored enterprises] today?

“The subsidies received by these large banks are large and extremely dangerous,” he said.