Economic Brief

August 2015, EB15-08

Living Wills for Systemically Important Financial

Institutions: Some Expected Benefits and Challenges
By Arantxa Jarque and David A. Price

The Dodd-Frank Act requires systemically important financial institutions

to create resolution plans, or living wills, that bankruptcy courts can follow
if these institutions fall into severe financial distress. The plans must set out
a path for resolution without public bailouts and with minimal disruption
to the financial system. While living wills can, in this way, help to curb the
too big to fail problem, regulators face a number of challenges in achieving
this goal. The authority granted to regulators by the Act, including the power
to make systemically important institutions change their structures, offers
promising means of addressing these challenges.
When Congress passed the Dodd-Frank Wall
Street Reform and Consumer Protection Act in
2010, the elimination of bailouts for distressed
financial institutions was among its goals. One
of the Acts measures in this regard was the creation of a new toolknown as resolution plans,
or living willsaimed at giving regulators
an enhanced understanding of, and increased
authority over, the largest and most complex
financial institutions. In particular, living wills
and their associated regulatory provisions are
intended to make these institutions, known as
systemically important financial institutions
(SIFIs), resolvable without public support if they
become financially distressed.
The need to make SIFIs resolvable without public
support has its conceptual basis in the idea of
commitment. Research has indicated that policymakers can reduce instability in the financial
system by making a credible commitment not
to rescue failing institutions, thereby inducing

EB15-08 - Federal Reserve Bank of Richmond

the creditors of these institutions to monitor and

influence the institutions risk-taking to a greater
degree.1 But given the uncertainty about the
costs to the financial system of letting a SIFI fail
outright, it is more difficult for policymakers to
make such a commitment without a roadmap
for winding down a SIFI in an orderly manner if
it becomes distressedthat is, a living will.
In practical terms, the provisions of Dodd-Frank
on living wills require these firms to produce
resolution plans to be followed in the event of
severe financial distress. On an annual basis, all
SIFIs must submit detailed plans to the Federal
Reserve and the Federal Deposit Insurance
Corporation (FDIC). With some work back and
forth between a SIFI and the agencies, a plan
ideally becomes a source of information about
the potential consequences of the firms failure
and how to minimize themalthough this information will necessarily be subject, in practice,
to considerable uncertainty.

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If the Fed and the FDIC find that the best feasible
plan does not set out a credible path to resolving the
firm without public support, they have the power
to require the firm to increase its capital or liquidity,
limit its growth, activities, or operations, and even
divest assets to make such resolution a credible
option in the future. This scenario is likely, given the
potential need of distressed SIFIs for large amounts
of short-term financing, the organizational complexity of SIFIs, and cross-border issues involved in
winding down a SIFI. Evaluating the need for such
changes, as well as the appropriate level of transparency for living wills, is no simple task. This Economic
Brief considers these challenges confronted by regulators who must oversee the transition of SIFIs to
resolvability, and some possible approaches to managing them.2
Short-Term Financing
One of the challenges facing policymakers is that
SIFIs in their present form have large liquidity needs.
In the event of distress, finding interim funding may
be important to minimize losses and market disruption. Hence, regulators assessing a living will should
consider who could realistically provide this funding.
When firms other than SIFIs are in bankruptcy, they
meet their short-term financing needs through
debtor-in-possession, or DIP, financing. This type
of financing, which must be approved by the bankruptcy court, is generally senior to the firms alreadyexisting debt. The firms creditors nonetheless are
commonly willing to approve DIP financing because
it keeps the firm in operation. DIP financing often
comes from private equity firms, hedge funds, large
banks, or existing creditors.
SIFIs, however, may face particular difficulties by virtue of the large amount of DIP funding they are likely
to need and because their bankruptcies may arise
during a period of broader problems in financial markets. By definition, SIFIs tend to be very large firms
and tend to have high short-term liquidity needs to
the extent that their business models are based on
maturity mismatch (for example, accepting deposits
that can be withdrawn on demand and using them
to fund long-term loans).

The question is, would a failing SIFI, given the financing needs that its size and structure imply, be able to
obtain sufficient DIP financing to see it through the
bankruptcy process? Would it still be possible if the
distress occurred during a time of market crisis, when
providers of DIP financing may be more cautious or in
distress themselves? If not, authorities may feel compelled to provide emergency financing, effectively
providing a bailout and encouraging moral hazard.
To maintain a credible commitment not to provide
financingthat is, not to rescue the firmpolicymakers may therefore need to limit the reliance of
some SIFIs on maturity mismatch. The combination
of very large institutional size and heavy reliance on
maturity mismatch should not be assumed to be
essential to financial markets. When reviewing living
wills, regulators may determine that if a SIFI wishes
to retain its large scale, it will need to reduce its
reliance on short-term liabilities. Alternatively, if the
firm believes that the costs of reducing its maturity
transformation would be unacceptable, it could
instead make itself smaller by shutting down certain
business lines or, more likely, spinning them off. Ease
of resolution should play, together with safety and
soundness considerations, a critical role in determining what constitutes acceptable practice in financial
intermediation. In contrast with safety and soundness regulations, which may limit short-term financing with the objective of preventing the failure of a
financial institution, the living wills process addresses
the expected need for DIP financing once the failure
has happened.
Once policymakers have established a credible commitment not to rescue firms in distress, the lack of a
safety net would cause the price of debt to become
more sensitive to the amount of maturity transformation, leading SIFIs to restrain their reliance on
short-term funding and reducing the need for DIP
financing.
Organizational Complexity
Another potential obstacle to making institutions
resolvable is that they may have highly complex
structures. One simple measure of this complexity is
the sheer number of entities within todays institu-

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tions: In 2012, six U.S. bank holding companies had

more than 1,000 subsidiaries, up from only one such
firm in 1991. Four of those six had more than 2,000
subsidiaries.3 The rise in complexity has come from
a number of circumstances creating economies of
scope and scale in the industry, making growth in
firm size and diversification attractive. A few of these
are technological scale economies, expansion across
state lines and globalization, and the rise of asset
securitization, among others.
One reason why complexity may be a hurdle to
unassisted resolution is that regulators might want
to separate the parts of the institution that are most
important to the stability of the overall financial
system (those that perform clearing and settlement
services, for example) and arrange for those to be
taken over by another institution. The larger the
number of subsidiaries, the more challenging it may
be to untangle their relationships and determine
which ones perform critical functions. In addition,
when bankruptcy courts resolve a large, complex
institution, their options may be constrained to some
degree by the existence of critical shared services
for example, information systems that are run by one
entity but relied on by other entities within the firm.
As with the challenge of short-term funding, to
the extent that regulators believe complexity may
stand in the way of unassisted resolution, the DoddFrank Act gives them the power to require SIFIs to
reduce their complexity. They might, for example,
direct the firm to spin off lines of business, consolidate subsidiaries, or duplicate certain functions to
make some entities more self-sufficient. Regulators
concerned with efficiency should seek to strike the
right balance, as changes of this nature will involve
adjustment costs and perhaps forgoing economies
of scope and scale. (A different case would be one
where complexity has been driven by the pursuit of
tax advantages; in this case, the increased tax burden
that may result from undoing that complexity should
not be a concern to financial regulators.)
Market forces should also prove helpful. Like the
amount of maturity mismatch, the degree of complexity may itself be partly a result of the expecta-

tion of support. Once regulators have established

the credibility of their commitment not to rescue,
debt holders will have an incentive to monitor institutions for excessive complexity that might reduce
their ability to recover their money in a bankruptcy
proceeding.
Cross-Border Issues
One aspect of the complexity of systemically important institutions is that they often operate across
numerous national boundaries. For example, when
Lehman Brothers failed in 2008, it had activities in
40 or more countries, leading to insolvency proceedings around the world.4
While supervision of these global institutions is an
everyday event in which cross-border matters are
dealt with routinely, resolution of the institutions is
a rarity, leaving room for uncertainty about what a
cross-border resolution would look like. Although
the optimal approach from a collective point of view
is for authorities in all countries with jurisdiction over
parts of the institution to cooperate in resolution to
maximize the value of the institution as a whole, the
incentives facing authorities may differ, since both
the losses from the failure and the available assets
may be of a different nature in different countries.
The possibility of multiple proceedings may be problematic due to inconsistent legal regimes in different
countries or difficulties in learning about an institutions foreign-based operations. When resolution
takes place within bankruptcy proceedings, crossborder coordination could be still more challenging
because courts may be less apt than administrative
agencies to coordinate internationally; cross-border
cooperation among courts, when it occurs, typically
occurs on a case-by-case basis, while financial regulators have had experience cooperating broadly on
issues, including resolution policy.
Part of the answer to these concerns about multiple
proceedings may be found in the notion of countrylevel separabilitythat is, making sure the local operations of an institution are resolvable independently
of its foreign-based entities. The more self-contained
and self-supporting an institutions operations within

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a country become, the less that cross-border issues

will reduce the value of the firm in resolution, and
the more credibly regulators can commit to a nobailout policy.
Country-level separability includes the ability of local
operations to function independently of a parent
that is based abroad. This independence includes,
for example, technology and financial support. Even
partial separabilitymaking significant progress
toward independence without attaining it 100 percentmay greatly reduce the need for international
coordination if the institution becomes distressed.
To be sure, separability comes at a cost, limiting
the adaptability of the institution in how it uses its
resources and where it positions them. Nonetheless, such costs will probably be necessary to some
degree to keep cross-border issues in resolution reasonably manageable.
Transparency
Even if SIFIs achieve financing structures and organizational structures that make them resolvable, this
outcome will not lead to market discipline if market
participants do not believe that it has happened.
Another challenge for regulators, then, is deciding
whether markets will accept the agencies own determinations about resolvabilityor whether markets
will need to see some of the underlying facts for
themselves. In other words, regulators need to decide
how much transparency in living wills is desirable.
When an institution submits a proposed living will to
the Fed and the FDIC, the institution itself designates
the material that will be included in the publicly
released section of the document, subject to the
requirements and approval of the agencies. In the
view of some, the outcome of this process has generally been a minimal level of public disclosure.5 This
is consistent with financial firms wishing to disclose
publicly as little as possible about their strategies
and operations.
The treatment of public disclosure by regulators so
far has been influenced by the longtime concern
for maintaining the confidentiality of proprietary

information in the supervision process. At the same

time, as noted earlier, the concern for maintaining
confidentiality of proprietary information must be
weighed against the need for a meaningful level
of disclosure about the firms ability to be resolved
without assistance. Moreover, in a democracy, voters
arguably have a legitimate interest in transparency
so they can assess the progress made in stabilizing
the financial system.
The right level of public transparency for living wills
is an open question. The Fed and the FDIC stated in
August 2014 that they are jointly committed to finding an appropriate balance between transparency
and confidentiality of proprietary and supervisory
information in the resolution plans and that they
will be working with SIFIs to explore ways to enhance
public transparency of future plan submissions.6
Conclusion
Living wills should help regulators make SIFIs resolvable through bankruptcy with minimal disruption to
the economy as a whole. This will increase the credibility of policymakers commitment not to rescue
these institutions, thereby curbing the problem of
too big to fail. But regulators still face significant
challenges in making these large and complex financial institutions resolvable. The challenges posed by
short-term financing needs, organizational complexity, and cross-border issues may require regulators to
use the enhanced authority granted to them by the
Dodd-Frank Act to impose changes in firm structure
that ensure resolvability. Market forces should eventually push firms toward such changes, as well
once the financial system understands that the living
wills process significantly decreases the probability
of bailouts. Sufficient transparency in the living wills
process is key to achieving this outcome. Reconciling
the need for transparency with the institutions need
for confidentiality will require careful crafting of a
regulatory solution.
Arantxa Jarque is an economist and David A. Price
is senior editor in the Research Department at the
Federal Reserve Bank of Richmond.

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Endnotes
1

For a classic explanation of the commitment problem, see

Finn E. Kydland and Edward C. Prescott, Rules Rather than Discretion: The Inconsistency of Optimal Plans, Journal of Political
Economy, June 1977, vol. 85, no. 3, pp. 473491. Research at
the Richmond Fed on commitment problems in emergency
lending includes Marvin Goodfriend and Jeffrey M. Lacker,
Limited Commitment and Central Bank Lending, Economic
Quarterly, Fall 1999, vol. 85, no. 4, pp. 127; Kartik B. Athreya,
Systemic Risk and the Pursuit of Efficiency, Federal Reserve
Bank of Richmond 2009 Annual Report, pp. 420; Borys Grochulski, Financial Firm Resolution Policy as a Time-Consistency Problem, Economic Quarterly, Second Quarter 2011,
vol. 97, no. 2, pp. 133152; and Jeffrey M. Lacker, Fed Credit
Policy: What is a Lender of Last Resort? Journal of Economic
Dynamics and Control, December 2014, vol. 49, pp. 135138.

This Economic Brief is based on the authors essay Living Wills:

A Tool for Curbing Too Big to Fail, Federal Reserve Bank of
Richmond 2014 Annual Report, pp. 417.

Dafna Avraham, Patricia Selvaggi, and James Vickery, A Structural View of U.S. Bank Holding Companies, Federal Reserve
Bank of New York Economic Policy Review, July 2012, vol. 18,
no. 2, pp. 6581.

Jacopo Carmassi and Richard John Herring, Living Wills and

Cross-Border Resolution of Systemically Important Banks,
Journal of Financial Economic Policy, 2013, vol. 5, no. 4,
pp. 361387.

See, for example, Carmassi and Herring (2013).

Board of Governors of the Federal Reserve System and the

Federal Deposit Insurance Corporation, Agencies Provide
Feedback on Second Round Resolution Plans of First-Wave
Filers, Joint press release, August 5, 2014.

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Federal Reserve Bank of Richmond and include the
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Views expressed in this article are those of the authors
and not necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.

FEDERAL RESERVE BANK

OF RICHMOND
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