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Third time yucky

30 November 2015 By George Hay

Banks that drag their feet on producing credible living wills could yet face a nasty surprise. The dozen biggest U.S. lenders will shortly find out whether the Federal Reserve and Federal Deposit Insurance Corp are inclined to flunk their self-penned resolution plans for the third time. In 2016, they shouldn’t assume this can be done with impunity.

There’s a good case to be made that living wills are a bit 2010. Watertight, exhaustive manuals on how big institutions would fail safely involve assumptions on top of assumptions about sale prices and market conditions. The U.S. stress-testing system, plus recently agreed cross-border guidelines on how to effectively capitalize themselves by converting debt to equity, are more important, and mean that living wills can seem like a superfluous bit of homework.

That misses the point. The Fed and FDIC already failed 11 of the 12 biggest players in 2012 and 2014, and would look silly yet again delivering only harsh words rather than action. Tough regulators like Fed Governor Daniel Tarullo have a limited window to get their more aggressive view of bank capital needs across ahead of November’s presidential elections. With the Republican-dominated Congress still trying to water down the Dodd-Frank Act, Tarullo won’t want his last act of the Obama administration to be a damp squib.

In theory, the rules allow regulators to order breakups or divestitures of the banks that receive failing grades on their living wills. Given lenders now hold much more equity and will soon have a buffer of so-called “bail-inable” capital worth 8 percent of assets, there doesn’t look to be a prudential case for doing so. But Tarullo could still make life difficult.

One way would be to speed up implementation of global Total Loss-Absorbing Capital rules from their current 2019 deadline. Alternatively, regulators could just make banks hold more equity capital. Tarullo told Bloomberg TV on Nov. 23 that banks’ 2016 stress-test pass marks could be ratcheted up.

It’s not definite that such an action would be motivated by revenge for banks’ insolence over living wills. But while American banks are on average better capitalized than their European peers, they still make returns below their cost of capital. If they’ve messed up on bank resolution yet again, their investors will soon want to know why.

 

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