April 19, 2016 | Commentary on Recession and Recovery, Economic Analysis, Regulation

Pull the Plug on 'Living Wills' for Banks That Are 'Too Big to Fail'

For the past few years, federal regulators have been working with the nation’s eight largest banks to develop “living wills” — contingency plans for how, if they become insolvent, they would close down without crashing the economy.

This month, the feds announced that the plans submitted by five of those banks were simply not credible. In other words, they failed their too-big-to-fail tests.

The 2010 Wall Street Reform and Consumer Protection Act, aka Dodd-Frank, requires bank holding companies with at least $50 billion in assets, as well as specially designated nonbank financial firms, to submit credible plans to the banking regulators. But there are many problems with the living will concept.

For starters, it is based on a faulty premise: that the bankruptcy of any large financial firm would inevitably tank the economy.

There simply is no solid evidence for this proposition. Indeed, the very idea behind bankruptcy is to provide an orderly resolution of failed firms. A main cause of the too-big-to-fail problem is that we’ve been treating banks as if they can’t be allowed to fail.

This special treatment for banks is a dangerous road that we should have never gone down.

How many workers and small businesses throughout the world depend on Wal-Mart to earn their living? It’s easy to make the very same economic case for treating any large nonfinancial firm special too.

Telling people that it’s fine to conduct any sort of business they choose because the government will cover their losses is a recipe for disaster, and this applies to all forms of industry.

Another problem with these “living wills” is that they amount to forcing firms to profess how they would resolve themselves based on unknowable information. How can any manager of a large bank know, for example, which assets it will sell, to whom and at what price, in the event of a crisis?

A more generous view of the living will equates it with a sort of prepackaged bankruptcy. But this analogy fails miserably because the living wills have no buy-in from the firms’ creditors. The creditors don’t even see the firms’ plans, much less agree to them.

Separately, a major downside to the living will process is that it gives federal regulators virtually unchecked power to micromanage companies in the name of financial stability.

If, for example, regulators deem a firm’s living will unacceptable, they can force the company to raise more capital, to downsize, or even to lop off particular segments of their business. Put differently, regulators can use the living will process to redesign a company.

This sort of unconstrained government power is wholly incompatible with anything close to free enterprise or, for that matter, a system of limited government.

The great irony is that the very government regulators — the Federal Reserve and Federal Deposit Insurance Corp. — that flunked these banks are largely responsible for creating the too-big-to-fail problem in the first place.

Expectations of emergency loans from the Fed and loan guarantees from the FDIC create exactly the wrong incentives in financial markets. How careful should anyone be when dealing with banks that clearly have access to government-guaranteed funds?

Rather than fix this incentive issue, Dodd-Frank worsened it.

So what would actually happen if a large bank became insolvent and simply went through bankruptcy? There is no way anyone can predict the exact outcome — rosy or otherwise.

But here’s a fun fact. The U.S. had more than 2,200 bank failures from 1984 to 1999 (with total deposits of more than $535 billion), and only 543 failures from 2000 to 2015 (with deposits of $496 billion — about $40 billion less).

There are certainly many ways to look at these stats, but it’s clear that the economy was infinitely more prosperous when we experienced almost five times the number of bank failures.

It’s at least plausible that bank failures aren’t as dangerous as everyone seems to think.

 - Norbert Michel is a research fellow specializing in financial regulations and monetary policy in Roe Institute for Economic Policy Studies.

 - This piece originally appeared in The Washington Times.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies