All around the world, banks are beginning a macabre process that is enough to strike fear into the heart of any investor: they are drawing up “living wills”, or more prosaically, creating plans governing what they would do if they were to collapse tomorrow.

Living wills and other measures, such as explicitly allowing regulators to force losses on senior bank creditors in a process known as “bail-in”, are all part of the official response to the risk of a bank’s sudden demise following the chaos created by the fall of Lehman Brothers in September 2008.

Then, it was clear few knew what to expect when one of the bastions of the financial system disappeared overnight. Now, the effects of that experience are clear in the recent blows to the shares and bonds of many European banks, even some of the biggest, on fears that a sovereign default by one of the region’s weaker countries could send another institution the way of Lehman.

Detailed resolution plans were first floated in late 2008 as regulators and bankers sought to contain market turbulence. Tony Lomas, lead administrator for Lehman’s European operations, likens the idea to the sort of recovery plans companies formulate for disasters such as earthquakes or terrorist attacks.

“Nothing changed with regard to [Lehman Brothers’] physical status,” he says. “But because its legal status changed, there were massive implications. If we had walked in here on that Sunday [when it collapsed], and there had been a manual there that said, ’Contingency plan: if this company ever needs to seek protection in court, this is what will happen’ – wouldn’t that have been easier?”

Those plans are now being put in place, and in detail.

Some of the work is as seemingly simple as knowing which of a bank’s hundreds of legal entities actually holds, say, the group’s Microsoft software licence. But much more is about working out disaster scenarios with regulators and units all over the world to factor in local laws and practices, should the worst happen. Other parts of the planning, such as listing who might be a likely buyer for parts of a business, are extremely commercially sensitive.

At the beginning of October, the Financial Stability Board, the Switzerland-based global regulatory agency, said all large international institutions would be required to write “resolution and recovery plans” and it set a tentative deadline of December 2012. That also includes a demand that regulators develop their own plans for dealing with each institution they supervise. They must also create cross-border groups with their peers to handle the biggest banks of all.

Banks are at difference stages of the process. Spain’s Santander sent its plan to the Bank of Spain in February last year, for example, while all UK banks should have plans in place by the end of this year, and many of the largest have already taken part in a pilot scheme that worked through the issues.

The UK requirements, which also cover investment firms with more than £15bn ($24bn) in assets, have two parts. First, institutions must spell out what actions they would take to raise funds if the business became troubled. Then they have to detail how best to unwind the business. Many other European countries are, however, waiting for the European Commission to finalise its plans, so they can include all the different requirements in a single exercise.

Living wills are meant to reassure investors, as well as regulators, that another bank collapse would not cause as much chaos as the previous one. But the plans have not smoothed the way for other post-Lehman reforms such as bail-in. This involves forcing losses on a bank’s senior bondholders to recapitalise a bank, but without it necessarily going through bankruptcy, where they would expect to take losses. The name stems from the idea that a bank’s creditors should be “bailed in” before taxpayers are called upon for a bail-out.

This has proved controversial. Although, in private, many banks and bondholders accept the principle that senior creditors should share the burden, they warn bail-in would be dangerous in the current environment, given the risk that investors elsewhere could take fright at the notion of losses, pushing up all banks’ borrowing costs.

This happened in January, when markets were spooked by Europe-wide proposals for bail-in. More recently, Denmark, the only country to have forced losses on creditors in two banks, has stepped back from bail-in. It will still allow it, but there are plans to also widen the available remedies for struggling institutions.

Ireland, too, has stepped back from the angry threats made by politicians during its election earlier this year, who demanded to “burn” the bondholders. The new government has not pushed ahead, and has instead focused on junior bondholders, who are paid more in interest for accepting a greater risk of losses.

Other countries are continuing this process. The conclusions of the UK’s Independent Commission on Banking in September were blunt: “There is no reason why investors in bank debt should not also be exposed to loss,” it said.

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