'Living Wills' for Banks are Pointless Without Market Discipline

Last week's rejection of 11 large financial institutions' living wills was a dramatic gesture by the Federal Deposit Insurance Corporation and the Federal Reserve. The living wills are supposed to be a roadmap for the orderly resolution of these companies, should they run into trouble. Living wills make good sense, but until markets are forced to live by them, there is little incentive to get them right.

The Fed and FDIC rejected the living wills, which were filed in October 2013, for falling short in a number of areas. Regulators took issue, among other things, with the banks' "assumptions about the likely behavior of customers, counterparties, investors, central clearing facilities, and regulators" and their "failure to make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for orderly resolution."

The banking agencies sent the affected firms back to the drawing board and threatened to take matters into their own regulatory hands if the plans do not pass muster the next time around. Dodd-Frank empowers regulators to impose growth, leverage, capital, activity, and other restrictions on companies that do not produce credible living wills. If, after such a regulatory reprimand, a firm still fails to produce a credible living will, the regulators can force it to sell assets.

The FDIC should not be surprised that the firms employed unduly rosy assumptions. After all, the FDIC's own assessment of how it would have resolved Lehman under its new Dodd-Frank orderly liquidation authority was grounded in similar wishful thinking. The FDIC assumed, for example, that in an FDIC-run resolution Barclays would have acquired Lehman's assets and some of its liabilities without inciting concern from regulators in the United Kingdom and with only "minimal ... disruptions to the market." And Lehman's general unsecured creditors would have received 97 cents on the dollar because of how well the FDIC would run the bidding process.

Living wills are a good idea. They help firms think through their organizational structures and points of vulnerability. A well-crafted living will provides useful insight to a firm's managers, shareholders, and creditors. As FDIC Director Thomas Hoenig explained in a statement last week, a credible living will is a powerful rejoinder to the false notion that bankruptcy is not a viable option for large financial firms.

Mr. Hoenig also argued that "a greater part of these plans should be made available to the market, providing it an opportunity to judge whether progress is being made toward having credible plans." Letting markets judge the credibility of living wills would not only harness the market's broad expertise, but also would send a message that regulators are serious about allowing firms to fail without government support. Speak now, bank creditors and shareholders, or forever hold your peace.

The existence of Dodd-Frank's orderly liquidation authority undercuts that tough message and diminishes the urgency of crafting a credible plan. When push comes to shove, regulators accustomed to micromanaging financial firms likely will want to micromanage resolution. Title II of Dodd-Frank gives them the power to do so.

When a friend of mine was set to deliver twins, she presented her birth plan-complete with musical choices and pain-killer preferences-to the doctor. "Birth plan!" he proclaimed with disdain as he shredded the carefully crafted plan. "We'll do things according to my plan." Good plans will only emerge if markets and regulators believe that resolution plans would actually be used in a time of crisis.

As the big banks consider how to redo their living wills, policymakers should take parallel efforts to revamp the bankruptcy code and eliminate regulators' ability to skirt bankruptcy in a time of crisis.