‘Too big to fail’ banks and the US government are playing an incredibly dangerous game

The eight largest banks in the US are struggling to tell federal regulators just how they would die, and it could be because the two sides are playing a very dangerous game.

When we say “how they will die” it’s not some morbid curiosity. The eight “too big to fail” banks are required to submit a document called a living will to the FDIC and the Federal Reserve. This would describe how, in the event of a 2008-like financial meltdown, the institutions could unwind without needing another bank bailout or crashing the US economy.

On Wednesday, five of the eight banks failed this test outright, while two more received just one of the two necessary approvals. Only Citigroup got the sign-off from both the Fed and FDIC.

The thing is, these living wills aren’t just a parliamentary disagreement. In fact, they show just how far apart the regulators’ and financial institutions’ thinking are.

How in three years are the banks barely inching closer to passing living wills? Is it simply a misunderstanding or something bigger, and potentially more worrying?

A simple misunderstanding

Let’s start with the benign option — it’s all just a misunderstanding.

One of the biggest issues with the living wills, and possibly the source of the delay, is that all of the things that the regulators are looking for are intentionally impossible to define. The Fed and FDIC use “qualitative” rather than “quantitative” measures, so the banks can’t just go through a checklist and be done with the process.

An example of this comes from JPMorgan. After failing the living will test in part for liquidity concerns, CEO Jamie Dimon said the company was incredibly liquid.

“The liquidity of the company is extraordinary,” Dimon said during a quarterly earnings call.

“$400 billion in essential banks around the world, $300 billion of AA plus short duration securities, just about 300 billion dollars of very short-term secured, really top-quality repo type of stuff like that. The trading book is $300 billion, which is mostly very liquid kind of stuff, so the liquidity of the company is extraordinary.”

Obviously Dimon’s understanding of liquidity and the regulators don’t match up. It seems this confusion may permeate the broader exercise as well.

Jamie dimon Lloyd Blankfein wall street ceo
Executives from the financial institutions who received TARP funds, (L-R) Goldman Sachs Chairman and CEO Lloyd Blankfein, JPMorgan Chase & Co CEO and Chairman Jamie Dimon, The Bank of New York Mellon CEO Robert P. Kelly, Bank of America CEO Ken Lewis, State Street Corporation CEO and Chairman Ronald Logue, Citigroup CEO Vikram Pandit, Wells Fargo President and CEO John Stumpf testify before the House Financial Services Committee February 11, 2009 in Washington, DC. Chip Somodevilla/Getty Images

“This is a highly hypothetical scenario, that makes it tough to get it just right,” Joo-Yung Lee, Managing Director and head of North American Financial Institutions at Fitch Ratings told Business Insider.

“The regulators are saying ‘basically tell us how you’re going to die and what is going to happen after’ and that’s not easy to do.”

In this scenario it is encouraging that the banks are making some progress. Last year all 8 banks failed outright, so having a total pass and two half-passes is progress, it shows they are learning the language of the regulators.

Ideally, as the banks get more of a feel for what the regulators are looking for, they will meet the targets and pass.

‘A game of chicken’

Now there’s also another option, and this one is a bit more dangerous.

The banks and regulators could know exactly where the other stands, and are simply being stubborn in order to “win” the negotiations.

“It is a little bit of a game of chicken,” said Roy Smith, professor at the NYU Stern School of Business and former General Partner at Goldman Sachs.

“There are some deeply held beliefs on both sides and it’s hard for them to come together to agree on what these wills are supposed to look like.”

The regulators want serious commitments from the banks, said Smith, and the banks don’t want to say anything that could come back to haunt them. That creates a stalemate.

Pushing boulder
Stalemate. Russ Brady/Flickr

“It’s not that there is a misunderstanding, it’s that regulators want serious concessions such as selling off or closing down trading desks and capital markets groups,” said Smith.

“Banks don’t want to put that down in writing because those are profitable businesses and anything they say about that could come back and be used by regulators to haunt them if some sort of downturn were to happen.”

To Smith’s mind, regulators want in writing that the banks would divest trading assets to the point that the firms would go back to the time of the Glass-Steagall act, which kept investing and commercial banking separate. Banks don’t want to have the possibility of losing that profit and are trying “to get through this without giving up anything they don’t want to.”

So each side knows where the other one stands, they’re just not willing to budge.

If no settlement is made this could be a serious problem, both for the banks and the regulators.

Without a living will, regulators can begin to impose serious penalties on banks, crushing profits and hurting their businesses. And if regulators don’t get actual results they will be seen as ineffective and face pressure from other government institutions.

Both of these outcomes could have negative consequences for the economy, especially if banks become significantly less willing to offer credit to businesses and consumers.

‘A proxy for wider issues’

In fact, the living wills may be just one front of a much larger war.

“You could make the case that this is a proxy for wider issues, for a larger back and forth between the two sides,” said Smith.

Essentially, living wills are just a substitute for a fight between two ideologies over the place of large banks in the US economy which could make the disagreements even more entrenched.

Even if this is not the case, the discussion of living wills is not going away said both Smith and Lee. The banks have until October 1 to resubmit edited proposals for 2016, and must submit another plan in 2017.

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