Three years ago this month, the true depth of the worst financial crisis since the Great Depression was becoming apparent following the acquisition, collapse and/or federal intervention to prop up of several of the largest financial firms in the U.S., some of which had been around since before the Great Depression. Three years removed from the brink of financial disaster, the Federal Deposit Insurance Corporation (FDIC) adopted a final rule implementing a provision of the Dodd-Frank Act requiring systemically important financial institutions, or SIFIs -- like the ones that failed, folded or were put on life support in 2008 -- to implement so-called "living wills" or, more technically, rapid resolution plans. The Federal Reserve is expected to adopt the same proposal in the next few days, finalizing a regulatory requirement that will fundamentally alter how companies act and react in the context of financial distress, as well as the role that regulators may play in that process. It will also require SIFIs to incur significant costs, and regulators to dedicate significant resources, in implementing, evaluating and updating the living wills.
The purpose of the living will, of course, is to provide a plan for the rapid resolution of a financially distressed company, which was specifically the case with a number of financial firms in September 2008. While it is impossible to know if things would have turned out differently for some of these institutions (or the broader financial markets) if they had such living wills, it is instructive to consider what could have happened if these firms had implemented and executed a Dodd-Frank living will. Certainly, what should have happened under the Dodd-Frank provision was a more orderly -- and perhaps market saving -- wind down of several companies. Under a best case scenario, perhaps some institutions would have survived albeit on a much smaller scale and different platform, and the financial markets would have absorbed the news and reacted differently than its wholesale lockdown of normal market operations. At the same time, there is the possibility that some of the current survivors may not have been so fortunate under the Dodd-Frank living will process.
Assuming for a moment that these firms had a Dodd-Frank living will in place, what would have happened and when?
With the first signs of financial distress, a SIFI would have had to initiate extensive conversations with federal regulators. While this happened in 2008, under Dodd-Frank it would start much earlier, occur more frequently, and with significantly broader input and oversight from numerous federal regulators, including the Federal Reserve, FDIC, Securities and Exchange Commission and, of course, the Treasury Department. The company would also be conferring with many of its existing counterparties in order to attempt to see what portions of its business could be sold or partitioned off from the financial turmoil affecting the rest of the company. Finally, the SIFI would have had to execute in very rapid fashion the key components of its plan to carry out its dismantling. Pursuant to Dodd-Frank, this effort would have included raising capital by selling off the most valuable pieces of the company, minimizing risks and exposure to the company's operations and overall enterprise, and, most importantly, minimizing fallout on the broader financial markets.
Under Dodd-Frank, the role of the federal regulators would certainly have been important with respect to the rapid resolution and wind down of the SIFI, but would have been critical in identifying the company's various interconnections and interdependencies and attempting to protect such other companies and market segments from the firm's financial distress.
Interestingly, with or without Dodd-Frank, the end-game for several firms -- bankruptcy or a forced acquisition -- would not have changed. However, with a living will, these SIFIs would have had a plan in place to identify a range of specific actions to facilitate a firm's rapid and orderly resolution, including that of the SIFI's material entities, critical operations and core business lines. Among the more important aspects of the plan would have been the funding, liquidity, support functions, and other resources available to maintain and fund the company's material entities, core business lines and critical operations during its wind down and/or forced acquisition.
While it is tempting to think that things could have turned out differently for some of these firms if they had implemented and executed a Dodd-Frank living will, the reality is that probably not much would have changed. Less clear, however, is what would have happened to the markets with an orderly wind down of these firms. This, of course, is the real test of the effectiveness and wisdom of the Dodd-Frank living will provision. Equally important is the cost paid, individually and collectively, to implement the living will and other provisions of Dodd-Frank.
As we look to the regulatory implementation of Dodd-Frank, it is important to remember that individual events and circumstances can influence macro-events, which is the painful lesson of the firms that failed or were forced to sell in 2008. That does not mean, however, that regulatory reforms should be made at all costs, but rather that the cost borne by those affected by regulation must be considered based on the aggregate benefit and weighed against the collective cost of reform. While a strong case for the Dodd-Frank living will can be made based on the experience of companies that did not survive the financial crisis, it is only effective and desirable from a regulatory perspective if things would have turned out differently for the broader financial markets with the living will requirement in place. This we do not know, but that does not mean we should accept at face value things will necessarily be different the next time around. We must still ask the question... will it make a difference and is it worth the cost?