THE BLOG
08/20/2014 02:08 pm ET Updated Oct 20, 2014

Breaking Up (the Banks) May Not Be Quite So Hard to Do

ASSOCIATED PRESS

As America approaches the sixth anniversary of the 2008 financial crash, here's an encouraging thought: The mega-banks can be broken up. It's already in the law. Forty-one words of the 2,000-page Dodd Frank Wall Street Reform Act empower the regulators to take this step. To exercise this momentous power, the regulators must take some initial steps in preparation. And on August 5, 2014, the regulators did just that.

Some background: On September 15, 2008, Lehman Brothers declared bankruptcy. Normally, bankruptcy serves as an orderly means to either close a business or reorganize it. Creditors suffer a reduction if not complete loss of the funds lent to the bankrupt company. Lehman's bankruptcy, however, triggered contagion throughout the economy. Why? Because its size and complexity touched too many creditors. When some of the same internal problems Lehman suffered became manifest at other mega-banks, Washington responded with bailouts for them rather than triggering more unmanageable contagion from bankruptcies. These banks were simply too big to fail (TBTF). What's more, the government's crisis managers actually made the TBTF problem worse by consolidating some of the smaller, failing firms, with the largest failing firms. To JP Morgan's sprawling empire, for example, the government added Bear Stearns and Washington Mutual.

The Dodd-Frank Wall Street Reform Act attempted to address TBTF with numerous provisions. In Section 165, mega-banks must adopt "credible" provisional bankruptcy plans colloquially known as "living wills." To be credible, they must prove to regulators that their failure could be handled in an orderly fashion and would not trigger financial contagion or require public funding assistance. If regulators determine they are "not credible," regulators can order changes, including divestiture of assets -- a break-up. These powers are contained in 41 words of the Dodd-Frank statute.

On August 5, the Federal Reserve and Federal Deposit Insurance Corp. declared that the "living will" plans by 11 large banks submitted in 2013 are "not credible." The 11 banks are Bank of America, Citigroup, JP Morgan, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, State Street, and the US units of Barclays, Credit Suisse, Deutsche Bank, and UBS.

Six years after the financial crisis demonstrated that the mega-banks are too big to fail, regulators have now officially determined that more must be done before one can fail without triggering a bailout.

Why did the banks fail to submit credible plans? Some argue that the banks' failed intentionally. They don't want to produce a roadmap for orderly deconstruction because, at the point of failure, they want a government bailout. FDIC Vice Chair Tom Hoenig provided some evidence for this theory when he expressed dissatisfaction that the mega-banks derivatives portfolios hadn't be altered to make them part of the bankruptcy process. Currently, derivatives can be settled immediately with the declaration of bankruptcy even as other credit relations must wait for the court. Derivatives are the bets banks make, largely with other banks. About a third of the world's $700 trillion in outstanding derivatives bets are held by just four American banks.

Another possibility is that the firms are so large and complex that any living will, even one composed in good faith, is doomed by its very size and complexity. Some living wills are reportedly 10,000 pages long. That represents an enormous number of steps all of which must proceed seamlessly. These steps would include assumptions that creditors would accept concessions at certain rates, that buyers would purchase assets at certain prices, that key managers would stay to clean up. The sheer number of such assumptions let alone the probability built into them begs confidence.

And either theory can't be tested by the public because the plans aren't public. If plans were made public, creditors and others could assess their viability. Market forces, such as the stock and bond prices, would serve as discipline.

Short of credible, public plans, the recent stern comment from the regulators constitutes a welcome castigation. This statement is perhaps a reflection of a tougher posture under new Fed Chair Janet Yellen. "The Federal Reserve Board determined that the 11 banking organizations must take immediate action to improve their resolvability." If these plans don't pass the credibility test by next year at this time, the regulators continued, "the agencies expect to use their authority." That authority means the regulators "may" order stronger capital levels, or divestiture of operations. Capital is roughly the difference between assets and liabilities. That difference is about 6 percent of assets currently. The percentage can be raised if the banks sell more stock, reduce or eliminate dividends, reduce compensation or other expenses, or sell assets.

Credit clearly goes to FDIC Vice Chair Tom Hoenig. The Federal Reserve and the Federal Deposit Insurance Corp are jointly responsible for the "living will" analysis. Vice Chair Hoenig released a forceful, candid statement on August 5 saying, "The Living Wills . . . demonstrate little ability to cope adequately with failure without some form of government support. The economy would almost surely go into crisis."

Credit also the ever vigilant Sen. Elizabeth Warren (D-Mass.). She highlighted the issue when she queried Chair Yellen at a July Senate hearing. "Has JPMorgan ever gotten to a plan, which you can stay with a straight face, is credible?" Whereas Lehman held $639 billion in assets in 209 subsidiaries, JP Morgan has $2.5 trillion in assets in 3,391 subsidiaries, observed the senior senator from Massachusetts. She instructed the Fed chair: "I think the language in the statute is pretty clear.. . . There are very effective tools that you can use if those plans are not credible . . . break them up."

Many rightly worry that regulators aren't applying Dodd-Frank's statutes rigorously enough that "never again will America be held hostage to a bank that is too big to fail," as President Obama promised. And there is at least one year more that regulators have given themselves before they may fail the mega-banks living will plans again and consider capital or divestiture requirements.

All that said, the August 5 declaration by the regulators is an important step that could lead to what most outside and many inside observers believe is the real answer for credible living wills: a breakup of the mega-banks.