Checklist Description
This checklist looks at the case for banks to write “living wills,” documents that detail their structure and main assets to assist regulators and administrators to dismantle a bank in the event of its collapse.
Definition
The bankruptcy of investment bank Lehman Brothers in September 2008 rocked the financial markets and shook confidence in the strength of the global banking system as the credit crunch intensified. Administrators faced a gargantuan challenge in dealing with the aftermath of the failure of the fourth biggest US investment bank; at the point of its collapse, Lehman had US$613 billion in debts and US$639 billion in assets, including US$43 billion in property alone. The bankruptcy judge overseeing the case described the collapse as the “most massive cross-border insolvency in the history of the world;” globally, Lehman consisted of 3,000 legal entities and has since become the subject of 76 individual insolvency procedures. Yet administrators arrived faced with the challenge of understanding and then winding down a global business with around US$1.2 trillion of open market exposure, with risks spread across a hugely complex organizational structure.
In September 2009 the United Kingdom, which had previously stepped in to rescue banks such as Northern Rock, the Royal Bank of Scotland and Lloyds Banking Group, revealed plans, through the Financial Services Authority regulator, to oblige banks to create “resolution and recovery plans” which would give administrators a head start toward dismantling banks in the event of their bankruptcy. Although similar plans have been floated elsewhere, the UK government has been a particularly active proponent of living wills. However, it stands opposed to the forced separation of retail and investment banking activities, despite support for this separation voiced by none other than Mervyn King, governor of the Bank of England. Such a radical move would be reminiscent of the changes instigated by the imposition in the United States of the Glass–Steagall Act of 1933, which enforced the separation of banking and broking activities.
Advantages
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The creation of living wills would be of immense benefit to administrators faced with the challenge of dismantling failed institutions with complex structures.
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Moves to clarify and simplify the structure of banks could also ease the process of integrating successful banks during a merger or acquisition.
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Although some banks may be reluctant to support the move toward the creation of living wills, those majority-owned by the state may be less able to resist pressure to impose this requirement.
Disadvantages
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Some institutions could resist pressure to create living wills on the grounds that their balance sheet strength makes failure highly unlikely.
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The creation and maintenance of living wills entails a resource overhead which some institutions may balk at.
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These documents would be highly sensitive and confidential in nature, with their creation potentially creating greater scope for uncertainty and instability over the strength of some banks.
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Moves toward simplified structures could also have adverse tax implications for banks that have created complex, opaque structures specifically to minimize their tax liabilities. The impact on profits could lessen their attractiveness to shareholders.
Action Checklist
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Some banks have already created structures that could simplify administrators’ tasks in the event of failure.
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For example, the HSBC has stated that each of its national units holds capital separately in its operating country, simplifying the job of regulators in dismantling the global structure should Europe’s largest bank ever fail.
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Nevertheless, regulators need to address complex issues surrounding living wills for cross-border banks, such as conflicts between different insolvency procedures and “burden-sharing” between authorities should taxpayers’ funds be needed to support the orderly winding down of international banks.
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Some industry figures have questioned the motivation behind the push toward living wills, with some suggesting the likelihood of a hidden agenda that is more related to preventing banks from employing tax-efficient structures, with a view to raising government income from corporation tax.
Dos and Don’ts
Do
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Recognize the positive side of living wills; governments and regulators aim to facilitate the “orderly” failure of a bank, minimizing uncertainty and stress in the wider banking system.
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Living wills will also force banks to separate their trading and deposit-taking units. However, regulators should understand that forcing banks to hold more capital reserves, such as required by the Basel II framework, to cover risks in their trading arms could adversely impact the amount of capital available for lending by retail banks.
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As with conventional wills, banks’ living wills must address the issue of how assets are to be ring-fenced and allocated in the event of the will writers’ demise. In particular, they will need to address the issue of which elements of the assets are to be protected and how this should be achieved.
Don’t
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Such documents would be highly sensitive in nature, so banks would need to avoid any risk of leaks that could potentially trigger rumors and instability in the sector.
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Don’t “throw the baby out with the bathwater.” In proposing moves to make the structure of banks more transparent and generally less complex, governments and regulators could seriously undermine banks’ present business models.
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