Five Banks in Regulators’ Sights

C Adam Pfander

Five major US Banks have failed to satisfy regulators that their failure would not spell doom for the national financial system. JP Morgan Chase & Co., Bank of America Corp., Wells Fargo & Co., Bank of New York Mellon Corp., and State Street Corp. must now rewrite their living wills – contingency plans that spell out how a bank would wind down quickly in the event of collapse. The banks have until October 1 of this year to revise their plans to regulators’ satisfaction, or else they will be subject to restrictions.

Three banks produced living wills, sufficient to bar a complete rewrite: Citigroup Inc., Goldman Sachs Group Inc., and Morgan Stanley. The latter two, however, were cited by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve, respectively, as having serious issues with their contingency plans.

These banks must produce living wills under the Dodd-Frank Act, the primary financial regulation passed in the wake of the Great Recession. Each living will is analyzed by the FDIC and Fed to determine whether the Bank can adequately wind down, without sinking its counterparty banks or its subsidiaries (companies owned by other companies, but not necessarily operated by them). This action was deemed necessary after the failure experienced by Lehman Brothers during the Great Recession.

Lehman Brothers bank filed for bankruptcy in 2008 – the same year that it reached a market capitalization of $60 billion and controlled $639 billion in assets and $619 billion in debt. The collapse is estimated to have eroded $10 trillion in market capitalization from global equity markets, and threatened the longevity of many financial institutions. In the wake of its meltdown, the federal government had to bail out many of its partner institutions, who suddenly saw their Lehman assets become worthless.

Lehman’s case highlights the problem with banks that are “too big to fail.” While undoubtedly efficient, these large banks carry a lot of downside risk. To avoid another Lehman scenario, the Dodd Frank Act demands that banks be prepared for failure, and if they fail, they must limit the damage to their customers, partners, and subsidiaries. Many of the failing institutions were cited for having inadequate liquidity measures – that is, in the event of a crash, they would not have enough cash on hand to pay their obligations.  Others, like the BNY Mellon, were cited for having overlapping business entities, making it difficult to liquify particular entities if the need arose.

If these banks are unable to produce adequate contingency plans by October, they face further restrictions from the government. The Dodd Frank Act provides that failing institutions face increased capital requirements and severe limits on their activities. Ultimately, the federal government could get authority to break up a bank if it consistently fails. The Banks have all assured their investors that these issues will be redressed well before the deadline.

Regulators, however, are not confident in the banks’ ability to produce adequate contingency plans. Neel Kashkari, President of the Minneapolis Federal Reserve Bank, said in a speech on Monday that Dodd Frank does not go far enough to ensure the stability of the financial system. He believes that regulators must either break up the large banks, or simply allow such large institutions to go bankrupt.