August 13, 2009 7:50 pm

Idea of ‘living wills’ is likely to die quiet death

Why banks should be forced to make ‘living wills’

Preparing a will is usually an emotionally charged experience. After all, no one really wants to ponder their demise when they are in the prime of health. Nor is it pleasant to spell out difficult issues such as how to divide up all the family silver – or not.

But could the lessons learnt from preparing for death prove useful for the modern banking world? Some western regulators are tossing the idea about.

In recent months Treasury officials in Washington have been scurrying to create a so-called “resolution” regime, which would make it easier to wind up large banks if they fell into a crisis.

The British Treasury and central bank have gone further by suggesting that banks should be forced to write “living wills” as part of a resolution system. These documents would in essence force banks to stipulate in advance how their operations could be wound down in a crisis and how their assets might be distributed, in the hope that such clarity might help to avoid a replay of the type of panic that erupted when Lehman Brothers collapsed last autumn.

What spooked regulators and investors at the end of last year was not just the bank’s collapse, but the fact that it was unclear where Lehman’s assets lay, or who could claim them. Thus, by injecting more transparency – and forethought – into corporate structures, another panic might be averted, or so the argument goes.

Might it work? Both the US and UK administrators of Lehman, which are still untangling the entrails of the dead bank, back the idea. The only honest answer is that no one really knows. After all, predicting market panics is an art, not a science, as the events of the past two years have shown.

However, as the debate about living wills bubbles on, it is worth watching closely, not so much in terms of what it reveals about how future crises might play out, but for its implications for the banking world today.

The issue at stake revolves around a matter that often bedevils personal wills – namely, the tricky question of transparency. In order to make it easy to wind down a large bank, it is crucial to have structures that are relatively simple and streamlined.

However, in the past few decades, the largest banks in the world have stealthily built corporate structures that are fiendishly complex, straddling numerous borders and plagued with offshore entities. Lehman Brothers was but one example of that.

The pattern, of course, is no accident. After all, large investment banks excel in regulatory and tax arbitrage, and all that cross-border complexity and opacity enables them to exploit such loopholes with ease. The pattern is also one reason that the living will idea could be very controversial, if regulators ever try to push it through.

After all, if the banks were ever forced truly to streamline their operations, it might become that much harder to jump between tax regimes, for example.

To my mind, that is one very good reason that the living will idea should be roundly applauded, almost irrespective of whether it might help stem any future crises. The degree to which large banks have been allowed to get away with tax arbitrage in recent years is nothing short of scandalous (and potentially even more shocking than some of their pay practices).

But sadly, this is also one reason that the living will idea may never fly. Six months ago, the largest global banks were on the back foot in political terms as they reeled from the shock of the Lehman Brothers collapse. However, these days they are regrouping with startling speed.

And regardless of all the debate about moral hazard – or having banks that are “too big to fail” – the system is drifting into a pattern where the most dominant lenders are becoming more dominant than ever. Just look at the market concentrations emerging, say, in the wholesale swaps, foreign exchange or bonds arena.

Given that, the regulators themselves are increasingly wary about pushing too many controversial ideas through, not least because they are badly hampered by being fragmented along national lines. “We have got to pick our fights carefully,” one western official explains. Clamping down on the cross-border tax practices of the banks, for instance, is apt to look a battle too far.

That may yet change, if, say, another large bank tips into problems. But right now there is no sign of that. So if the concept of living wills gathers momentum in the coming months, I will applaud; but if it quietly dies a death, I will not be surprised.

Meanwhile, the core issue that living wills were supposed to address – the moral hazard that is raised when dominant banks are too big to fail – remains as alive as ever. And that is something that should worry us all, for the present, irrespective of the future.

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