Megabanks Are Unable To Prove They Aren’t Too Big To Fail

A core piece of the Dodd-Frank financial reform legislation appears to be bearing fruit, although perhaps not of the sort supporters of the law envisioned. Businessweek reports that the “living will” bankruptcy resolution plans that the largest banks are required to submit are falling far short of requirements. Those failures are inspiring “an increasingly vocal chorus” of calls for breaking megabanks up to reduce the risk of a future crisis.

Dodd-Frank’s “living will” requirement is central to its efforts to prevent future bailouts. Under the law, banks and non-bank firms designated large enough to endanger the whole economy must draw up plans for how they would be wound down should they go bankrupt. But the plans, which map out the firms’ connections to the rest of the financial system, aren’t satisfying the law’s requirements.

The first draft wills submitted by 11 banks last year were deficient to varying degrees, and revised wills are due in October. The Federal Deposit Insurance Corporation (FDIC) official in charge of planning out the emergency procedures created by Dodd-Frank told Businessweek that the first crop of plans from the banks “all had a ways to go” to satisfy FDIC concerns.

Republicans still insist the bill guarantees taxpayer bailouts in the future, and that it enshrines “Too Big To Fail” (TBTF) in law. But rather than providing evidence that Dodd-Frank fails to tackle the megabank problem, the failures of living wills would give regulators an opportunity to force such dangerously large firms to shrink.

If the revised plans this fall still leave FDIC unsatisfied, the agency could make firms with deficient plans “restructure” – that is, the government could break up megabanks that fail to prove they can be guided through bankruptcy without blowing up the entire financial system. One bank consultant quoted by Businessweek expects such forced restructuring to happen, and a bank lawyer notes that rather than risk being taken over and dismantled by FDIC due to living will failures, some banks are already “getting rid of businesses they shouldn’t be in.” That suggests Dodd-Frank may be having a stronger impact on the TBTF problem than previously thought.

But while the possible forced restructurings are still months if not years away, some are looking to break up the banks more directly. Sen. Sherrod Brown (D-OH) has proposed legislation designed to shrink banks. Federal Reserve officials, including Ben Bernanke himself, have said more must be done to combat the problem of TBTF.