Copycat living wills may see dealers avoid US fines

The similarities in the resolution plans of the world’s largest banks could make it difficult for regulators to single out any individual firm for sanctions

Safety in numbers: at least 111 of the 139 banks that will file resolution plans this year have farmed out the task to one of three New York-based law firms

Each spring, vast herds of wildebeest march across the African Serengeti in an annual spectacle dubbed the Great Migration. Sheer numbers are their best defence against the predators that relentlessly stalk them through the long, yellow grass, waiting to pounce on those who stray too far from the safety of the pack.

The world's largest banks seem to be following a similar approach when they submit their annual resolution plans – commonly known as living wills – to the US Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC) for approval each year.

Seeking safety in numbers, at least 111 of the 139 banks that will file resolution plans this year have farmed out the task to one of three New York-based law firms: Cleary Gottlieb, Davis Polk and Sullivan & Cromwell. Davis Polk alone drafted living wills for eight of the world's 12 largest banks – the so-called 'first-wave filers', which have been submitting living wills to regulators each year since 2012 – while Cleary and Sullivan represent the other four.

"When the resolution plans were introduced in 2012, no bank and no regulator had been through this process before, so no-one knew what to expect. Banks want to have some ability to compare and benchmark themselves against others, and if firms are contracting with the same law practices, they can get a sense of whether they are higher or lower in the pack relative to the resolution plans other banks are preparing," says an attorney that has prepared several living wills at a law firm in New York.

The herding rationale is simple: if everyone sticks to the same general template, compiled by the same law firms, then how can regulators single-out any individual bank for sanctions?

"Most of the major banks are using one firm because it provides some security. If one firm works on all of the plans, and the regulators say those plans are not good enough, then every bank will have to resubmit their living wills at the same time. As long as no bank is really any different from any other bank, they should all avoid sanctions," says a New York-based derivatives attorney at one US law firm.

That strategy worked like a charm for the first-wave filers. Regulators effectively rejected 11 of the 12 living wills submitted in 2013, with Wells Fargo the only one to get a pass. Yet none of the 11 banks that failed to submit credible resolution plans was sanctioned.

Plans savaged

It was a close call, however. The FDIC savaged the 2013 plans, calling them "not credible" in a public statement, and ordered the filers to "take immediate action to improve their resolvability". The Fed, meanwhile, adopted a more measured tone in its public statement, noting certain "shortcomings" with the plans and urging banks to address these in future submissions.

The language used by the regulators is more significant than it first appears. A joint determination by the FDIC and the Fed that a resolution plan is not credible exposes the filer to sanctions under the Code of Federal Regulations statute. The potential penalties include the forced sale or divesture of assets and the suspension of dividends. The FDIC, sources say, seemed willing to go down that path.

Thomas Hoenig, FDIC

The hawkishness reflects the hard-line positions of two senior officials – vice-chairman Thomas Hoenig and former director Jeremiah Norton. Hoenig has argued for years that some of the world's largest banks are still too-big-to-fail, and has spoken of the need for a workable resolution mechanism to dismantle these megabanks if they are ever put into bankruptcy.

"Hoenig is the one driving this agenda to reject the plans as 'not credible'. If, like him, you believe large banks are simply not resolvable, then of course you will think these plans are not credible," says a lawyer who has worked on several living wills. "If you have a more nuanced view, like that of the Fed and others in the FDIC, you may treat this process as one where we make credible steps towards creating a resolvable structure."

The Dodd-Frank Act requires large bank holding companies to submit resolution plans to the Federal Reserve and the FDIC on July 1 each year. These must describe the firm's strategy for rapid and orderly resolution under the US bankruptcy code in the event of material financial distress or failure of the company (see box: Banks lean towards single point of entry). After reviewing the plans, the Fed and FDIC make separate determinations as to whether the plans are credible or not. Alternatively, they can identify specific shortcomings in the plans and order banks to address these in future filings.

A joint determination that a plan is not credible could trigger sanctions.

But if the Fed or FDIC find shortcomings in a plan, the bank must re-submit it the following year, and need not take any immediate action to improve its resolvability.

The value of herding

Some say the FDIC's aggressive stance on resolution shows the value of the banks' herding strategy. "By working with one of those three law firms, banks were able to do a comparison across filers. Everyone wants to know what others are doing in that space. Banks could determine whether they were in the middle of the market, or if their plan is too light or too harsh," says the attorney at the first New York-based law firm.

This meant that when the Fed reviewed the resolution plans and found them all to be broadly similar, it faced a stark choice: deem all the plans to be "not credible" as the FDIC had done, and open the door to sanctions; or give everyone another chance to fix the "shortcomings".

The Fed was reticent to invoke sanctions over the 2013 plans and opted for a softer approach, say lawyers. A former regulator says it essentially determined the plans were "not not credible". Bankers and their legal advisers heaved a collective sigh of relief.

The FDIC and the Fed did not make public statements on the 2014 living wills, and instead directed the banks to address the faults in the 2013 plans in their 2015 submissions, which the first-wave filers submitted on July 1.

The threat of sanctions still hangs over the most recent plans. Hoenig has not softened his stance, sources say, and the philosophical differences between FDIC and Fed officials remain a source of simmering tension. "Hoenig's position is that these plans are not credible, while the Fed merely says there are some things that it wants to see improved in the future. There is some tension there," says the lawyer who has worked on several living wills.

Given the lack of public information, it's unclear how the 2015 filings will be received. Lawyers say there is an observable improvement in both the level of detail and the amount of information disclosed publicly in the 2015 living wills of the first-wave filers.

Wilson Ervin

"The public parts of the US living wills are much improved from previous years," says Wilson Ervin, vice-chairman in the executive office at Credit Suisse in New York.

"In the early days, most plans were fairly bare bones, with little or no discussion of strategy. Some simply laid out a series of options, like selling assets or divesting business lines. We now have a much clearer sense of the likely strategy – how the firm could use a single point of entry approach to recapitalise their banks and key entities. This also gives creditors some idea of how firms could use this approach to protect critical functions and how key legal entities across the group would be addressed. There is still work to do, but the 2015 public plans are vastly better."

Still, banks remain in the dark about whether the Fed and FDIC will reject their plans or levy sanctions. The FDIC and Fed can also choose not to make a determination – at least not publicly.

"There is no requirement for the regulators to state whether they accept the living wills or not. The regulation gives them the authority to determine whether a plan is 'not credible', but it does not say they have to make that determination public. There is also nothing in the rule that says they have to tell you if your plan is credible – they just tell you if your plan is not credible," says Michael Krimminger, a partner at law firm Cleary Gottlieb in Washington, DC, who spent more than 20 years at the FDIC.

It's also unclear how credibility is defined – it's only clear that the plan should allow for an orderly resolution under the bankruptcy code.

"We know, from the regulation, that it must substantially mitigate systemic risk, but there is not a lot of precedent for what the term means in this context," says Krimminger.

If the regulators choose to remain silent on the 2015 plans, it would leave banks in a bind. With no direction from supervisors as to whether they are satisfied with the wills, banks will be left wondering whether they should push ahead with the proposed structural changes or not.

For instance, the Fed criticised the 2013 plans for failing "to address structural and organisational impediments to an orderly resolution". Silence from regulators could leave banks wondering whether to go ahead with the proposed restructuring.

Improved resolvability

The attorney that has worked on several living wills says regulators expect banks to improve their resolvability, even if the plans are not officially deemed credible. "There are continual supervisory reviews where regulators get together and ask banks what progress they have made on a number of issues. So to the extent they have submitted plans to make themselves more resolvable, if they don't show progress around how they are going to overcome the impediments to their rapid and orderly resolution in the past 12 months, that would not be seen as helpful by regulators," he says.

Some see a loophole in the regulator's approach to assessing the plans, however. A determination that a plan is not credible exposes a bank to sanctions, while a determination that a plan is credible – or negative consent in the form of silence – would compel a bank to start implementing its resolution plan.

However, if at least one of the two regulators deem a plan has shortcomings, the bank would escape sanctions and have no obligation to make any immediate changes to improve its resolvability. Instead, it could spend the next 11 months putting together an improved resolution plan for next year's deadline, without making any of the changes proposed in its previous submission.

As all the first-wave filers are benchmarking against each other through their shared legal counsel, chances are that if one bank's plan is found to lack credibility, the same flaws will be found in all the plans. The banks could in theory re-submit their plans year after year, with no individual firm singled out for sanctions, and no action taken to improve resolvability – as long as they all remain within the protection of the herd.

"I could understand that approach," says a Washington, DC-based bank lobbyist. "The downside for the banks here is the potential for a fundamental restructuring of their operations, and perhaps even identifying parts of the business that are problematic for resolution and jettisoning those units. There are some real-life, hardcore consequences arising from the proposals they are putting into these plans."

 

Banks lean towards single point of entry

The US living will rules require banks to present regulators with a plan for resolution via bankruptcy, and a resolution plan under the orderly liquidation authority (OLA) granted to the Federal Deposit Insurance Corporation (FDIC) in Title II of Dodd-Frank, which is designed for a Lehman Brothers scenario where normal bankruptcy proceedings are not feasible.

Most US banks prefer a single point of entry (SPOE) resolution strategy, where the bank holding company is replaced with a bridge bank, its critical infrastructure continues to operate while buyers are sought for healthy units, and other business are put through a solvent wind-down (click here for table A).

Bank of America envisions a SPOE where its retail bank and several subsidiaries continue to operate in bankruptcy, while its global markets business is sold or wound-down. JP Morgan has a similar strategy, but prefers an OLA resolution that would see its retail bank reduced to one-third of its current size post-resolution, while its broker-dealer subsidiaries would shrink by two-thirds.

Goldman Sachs, Morgan Stanley and Citi say they will seek to sell businesses where possible and facilitate an orderly wind-down of all units that do not attract buyers. The bridge bank running the resolution would wind itself down once all the assets and businesses have been sold or liquidated. Citi's retail bank would survive, however, under the ownership of another entity following a divestment through a series of mergers, initial public offerings and asset sales.

The US Federal Reserve and the Federal Deposit Insurance Corporation release public portions of the living wills submitted each year. These run from 38 pages for Wells Fargo to 102 pages for Citi. However, the amount of useful information contained within is minimal – with most of the pages devoted to financial information regurgitated from the bank's annual reports.

Most of the pertinent information is restricted to regulators' eyes only, and can run up to 40,000 pages in length, according to lawyers. The astonishing length reflects the fact that banks must present several competing strategies for resolution within their plans.