One of the lessons learned from the 2008 banking crisis was the danger of allowing banks to become “too big to fail,” and therefore creating a drain on the U.S. Treasury through federal bailouts.
In response, government agencies devised a requirement for so-called “living wills” to gauge a bank’s vulnerability to economic shocks. Yesterday, 5 of the largest U.S. banks failed their tests and face possible regulatory sanctions.
The banks in question are J.P. Morgan Chase & Co., Wells Fargo & Co., Bank of America Corp., Bank of New York Mellon Corp., and State Street Corp. They have until October 1 to revise their living wills, which are their contingency plans to enter bankruptcy without taxpayers picking up the bill.
According to the Federal Reserve and the Federal Deposit Insurance Corp. (FDIC), all 5 banksfailed to comply with the legal requirements set out in the 2010 Dodd-Frank Act, which is supposed to insulate taxpayers from failing private financial institutions.
Regulators also uncovered weaknesses in the living wills of Morgan Stanley and Goldman Sachs and shortcomings in the contingency plans of Citigroup. The FDIC gave failing marks to Goldman Sachs, while the Federal Reserve rejected the Morgan Stanley plans.
Any banks that fail to meet the October deadline will be subject to sanctions such as higher capital requirements and limits on their activities or growth. Citigroup, Morgan Stanley and Goldman Sachs have until July 2017 to address the shortcomings in their living wills.
The 8 U.S. banks evaluated by the federal agencies are all designated “systemically important financial institutions,” or SIFIs, meaning their failure could risk the health of the overall economy.
FDIC Chairman Martin Gruenberg proclaimed that the regulators “are committed to carrying out the statutory mandate that systemically important financial institutions demonstrate a clear path to an orderly failure under bankruptcy at no cost to taxpayers. Today’s action is a significant step toward achieving that goal.”
Critics of big banks generally approved of the regulators’ verdicts. But not all analysts are fans of the living will law, citing several potentially negative effects, including the imposition of rules that depress lending, slow down the recovery of the banking sector, reduce market liquidity and weaken bank profits.
Nevertheless, bank stocks have rallied recently, in part due a report from J.P. Morgan that its earnings declined less than expected.
The criticism leveled at the banks included:
  • Bank of America was deficient in its ability to estimate liquidity needs and in its processes for triggering a bankruptcy declaration.
  • Bank of New York Mellon didn’t sufficiently support its strategy to declare bankruptcy and failed to simplify its legal structure.
  • State Street Bank was dinged for unrealistic assumptions about the amount of capital it would need to execute its living will.
  • Wells Fargo was judged to have committed substantial errors in the formulation of its contingency plans.
  • Goldman Sachs and Morgan Stanley need to improve their plans for sustaining their subsidiaries if the parent bank fails, and must further clarify plans to unwind their derivative contracts.