Bank Regulations and Living Wills

The FDIC and the Federal Reserve are competing in a race against time to regulate big banks before the next collapse that could tank the U.S. economy for the second time in a decade. The latest development this past week comes from the FDIC.

As introduced in Dodd-Frank from 2010, big banks must now write “living wills” to prevent another too-big-to-fail scenario. These wills describe how a big bank will break up assets and debts in the event of a meltdown.

The Financial Stability and Oversight Council (FSOC), chartered under Dodd-Frank, identifies system risks and crafts plans to diffuse them. The FSOC’s responsibilities include determining which banks are too big to fail. Just this past week, the FSOC determined that MetLife, the insurance goliath, is not considered a Systematically Important Financial Institution (SIFI).

Comprised of 10 voting members, including the secretary of the Treasury, the FSOC promotes market discipline by dispelling expectations that the federal government will bail out banks in the event of a failure.

The FDIC recently rejected the plans of five major banks: Bank of America, BNY Mellon, JPMorgan Chase, State Street, and Wells Fargo. These banks now have the opportunity to revise their plans within 90 days for another round of approval.

The FDIC can extend this deadline as it already has for a number of big banks. If the revised plans don’t garner approval from the FDIC and the Fed, regulators can force the banks to shrink assets and reduce risk now to prevent losses in the future.

Some of these “living wills” consider higher capital requirements. These capital requirements, however, do not fully account for the risks associated with these banks’ holdings of derivatives.

These financial derivatives are in a special classification of financial contract, and derive their value from an underlying entity. Common examples are credit default swaps and collateralized debt obligations.

One problem with the increased capital requirements is that the Fed and the FDIC cannot agree on what the current capital levels are. The level of capital determines how much loss a bank can endure before failure. A certain amount of risk accompanies this capital level.

Moreover, when the federal government requires that banks hold more capital to offset risks, banks are not allowed to invest this capital for additional profit, restricting their participation based on a percentage of financial investments.

In recent releases, the Fed maintains that the average capital holdings for the eight largest banks are 12.9 percent, well above required federal minimums. The FDIC contends that the same banks only held 4.97 percent, significantly below the required federal minimums.

The discrepancy in percentages stems from different evaluations of the risk posed by the banks’ holdings of derivative contracts used for investment. In typical American accounting rules, the gains and losses of financial derivatives net to zero. This allows accountants to alter the ratio of capital to assets to bolster the investing profile of banks for derivatives that do not appear on accounting sheets.

The FDIC on the other hand, uses stricter accounting rules that do not allow financial derivatives to net to zero. Using this method would add $300 billion to the balance sheet of the top five banks in America—JPMorgan Chase, CitiGroup, Bank of America, Goldman Sachs, and Morgan Stanley. Applying international accounting standards would add $4 trillion to the balance sheets.

The problem with these “living wills” is that they fail to account for a systematic collapse of the financial markets.