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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.