Recently, five major banks, including Bank of America (ticker: BAC) and JPMorgan Chase (ticker: JPM), failed to meet the recently rolled-out “living will” standards—a regulatory provision designed to prevent a company financial crisis from mushrooming into an economy-wide meltdown.
The new rules are part of the Dodd-Frank Act financial regulatory framework, the full features of which are still being sorted through. “Living wills” are one of many new regulations to which big banks must adhere and the regulation requires a mandatory annual report from the largest U.S financial institutions. Ultimately, this report is provided to the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC). In its living will, each bank must describe its plans to wind-down in an orderly manner in the event of a crisis without disrupting the broader financial and economic systems.
The regulatory framework itself is sensible, but the problem for banks and bank stocks is that Dodd-Frank regulations, nearly 8 years later, are still being written. Operating in a vortex of regulatory uncertainty is difficult and it can hamper appetite for risk. Less risk-taking typically means generating less new economic activity and that can be a headwind for stock prices.
Here’s a look at the recently released 2015 Living Will scorecard.
Five Banks’ Wills Rejected On Grounds of “Deficiencies”
Five banks, including Bank of America, Bank of New York Mellon, JPMorgan Chase, State Street and Wells Fargo, have “deficiencies” in their 2015 “living wills” or resolution plans, meaning they don’t qualify for orderly liquidation in the case of a bankruptcy and will therefore have to rework their resolution by October 1, 2016. If a bank’s plans fail to meet standards, even after the two attempts, it could face even tighter requirements.
Bank of America’s model for estimating liquidity requirements against a crisis was found to be inefficient. The regulators also objected to the bank’s governance mechanism lacking timely bankruptcy-related triggers.
On the other hand, regulators found deficiencies in operational and legal strategies in Bank of New York Mellon’s (ticker: BK) report. JPMorgan Chase, in addition to liquidity and legal inadequacies, was said to have insufficient plans for winding down its derivative portfolio should crisis strike.
Regulators found State Street Corporation’s (ticker: STT) bankruptcy resolution plans lacking in operational and legal capabilities, as well as in capital and liquidity requirements. Some shortcomings to be addressed in the 2017 plan were also identified.
And finally, Wells Fargo Corporation (ticker: WFC) was deemed to fall short of governance, operational and legal standards for orderly liquidation in case of a bankruptcy. Also, the bank’s governance deficiencies are thought to pose risks to resolution planning.
Citigroup Passes Test Abut with Some Shortcomings
While the Federal Reserve Board and FDIC did acknowledge certain “shortcomings,” particularly in governance triggers, none amounted to “deficiencies” in Citigroup’s (ticker: C) living will. Citigroup must address their shortcomings in the July 2017 plan. The regulators also noted some improvements in legal, liquidity and operational aspects in the bank’s plans.
Regulators Divided on Morgan Stanley and Goldman Sachs
Even as both agencies identified weaknesses, they could not come to a consensus on the status of Morgan Stanley (ticker: MS) and Goldman Sachs (ticker GS). The FDIC thought Goldman Sachs was deficient in its resolution plans, while the Federal Reserve Board thought Morgan Stanley’s plan would not hold up against bankruptcy. In absence of a unanimous decision, these weaknesses have been assigned the status of “shortcomings” that both banks must address in their July 2017 living wills.
Despite deficiencies and shortcomings, regulators have identified banks’ progress in various areas of their resolution planning—a hopeful sign amid caution.
Bottom Line for Investors
With living wills, U.S. regulators are aiming to make the process of bankruptcy less chaotic and more organized for the largest financial institutions, thereby stemming systemic spread throughout the entire economy. Despite probably being an overly-cautious regulation, it’s arguably beneficial in the long run for restoring investor confidence to banks. Banks groan with each new regulation thrown their way, but ultimately it’s not the regulations themselves that are a hindrance to stock prices—it’s the uncertainty of not knowing what regulation will come next. Too much risk can harm an economy, as we saw in the lead-up to the financial crisis, but regulators need to remember that too much caution can hurt too.
Disclosure