Using Living Wills to Break up Big Banks

By | October 11, 2016

One of the key areas of focus during Wells Fargo CEO John Stumpf’s recent congressional testimony, was the timeline of events that led up to him becoming aware of the problems within the company’s community banking division.  Despite the fact that the firm fired over 1,000 employees in 2011 for opening unauthorized customer accounts, and many more in subsequent years, Stumpf claimed in his testimony that he was not made aware of the issue until sometime in 2013.  Given that throughout his tenure as CEO, Stumpf met with the head of the community banking division, Carrie Tolstedt, on a weekly basis, it raises the question—what the heck did they talk about?

Stumpf’s inability to answer questions about what went on inside Wells Fargo frustrated many lawmakers and led several to conclude that this was yet another example of a bank that was too big to manage.  House Financial Services Committee ranking member Maxine Waters, D-Calif., became so exasperated that she declared: “I’ve come to the conclusion that Wells Fargo should be broken up.”

Waters went on to state that she would be “moving forward to break up the bank,” without providing details on how she would accomplish this.  A spokesperson later clarified that she would pursue legislation, a strategy that has little chance of success in today’s polarized political climate.  But what if legislation was actually not necessary to break up large financial institutions who have demonstrated an inability to effectively manage themselves, and whose failure could send shockwaves throughout the rest of the financial system?

Livings Wills

Section 121 of the Dodd-Frank Act gives the Federal Reserve and The Financial Stability Oversight Council the ability to break up the banks if they pose “a grave threat to the financial stability of the United States.”  As egregious as the fraud at Wells Fargo was, no one would argue that it threatened our country’s financial stability.  Dodd-Frank does provide a more precise tool through Section 165(d), which gives regulators the authority to force banks to “divest certain assets or operations” if they fail to submit a resolution plan, also known as a living will, that demonstrates the company can be unwound in an orderly fashion under title 11 of the U.S. Bankruptcy Code.  A number of procedural hurdles must be cleared before regulators consider divestitures a viable option, but given that Wells Fargo, and four other big banks, recently submitted revised plans to address previously identified deficiencies, regulators will face increased scrutiny to assess these plans with a critical eye.

This past April, the Federal Reserve and Federal Deposit Insurance Corporation (“the agencies”) provided specific feedback on the 2015 resolution plans of eight global systemically important banks (G-SIBs).  The agencies found the plans of Bank of America; The Bank of New York Mellon; JP Morgan Chase; State Street; and Wells Fargo contained deficiencies that undermine the feasibility of each firm’s resolution strategy.  In essence, a deficiency is something that the agencies think will make it harder to resolve a firm through the bankruptcy process.  These five banks were required to submit revised plans that remediate their deficiencies on October 1st, and the agencies are currently in the process of reviewing these plans.

The public portion of Wells Fargo’s recently submitted resolution plan sheds additional insight on the deficiencies regulators identified in the firm’s 2015 plan.  The agencies found the plan failed to identify critical shared services that would support the firm during its resolution.  In addition, the plan lacked specificity in identifying the criteria the firm uses to reorganize legal entities to better support the resolution process.  However, in light of the recent cross-selling scandal and debacle on Capitol Hill, it is the deficiency around the firm’s governance that stands out the most.

In their 2015 plan, Wells Fargo apparently submitted inaccurate information, and their feedback letter stated the firm needs to implement a robust “process to ensure quality control and accuracy regarding its resolution plan submissions and the consistency of financial and other information reported.”  To address this deficiency, the agencies stipulated that the firm must establish “mechanisms for independently verifying internal coordination and review and active oversight by senior management.”  This finding appears to corroborate the perception that Wells Fargo’s senior management team is not well-informed about what goes on within the firm.

Issues with Wells Fargo’s Resolution Strategy

Because over 90% of Wells Fargo’s consolidated assets are within their bank legal entity (WFBNA) they have adopted a somewhat unique resolution strategy compared to the other seven G-SIBs.[1]  Wells has proposed a bridge bank strategy, which would allow the FDIC to establish a temporary bank in the event of material financial distress at Wells Fargo, in order to: “maintain, and operate some or all of the business of the bank during the time between its failure and the time when the FDIC can implement a resolution strategy and return the bank to private ownership.[2]

After establishing the bridge bank, the company would transfer in the majority of WFBNA’s assets and liabilities, to be followed by the sale of “certain loan portfolios, business lines, and other assets that the Company believes would be desirable to purchasers on a stand-alone basis.”  Wells also believes that the FDIC will be able to create salable regional portfolios that will be enticing to banks that are interested in entering into a specific region, or growing their footprint within such region.

Regulators would be wise to question the feasibility of such a strategy.  Prior to the current scandal, Wells Fargo was thought to have had an extremely valuable retail banking franchise, driven in part by perceived customer loyalty, as measured by the average number of products each customer had with the bank.  The value of this franchise now stands much diminished, as does the ability of any future bridge bank to sell certain bank portfolios.  Given that fraudulent activity went unnoticed by senior management for so long, one wonders what additional surprises would await potential purchasers in a resolution scenario.

What Can Regulators Do?

Even if the Federal Reserve and FDIC find Wells Fargo’s recently submitted resolution plan fails to adequately address previously identified deficiencies, there are several steps before the firm would be forced to downsize.  First, the agencies, acting jointly, “may impose more stringent prudential requirements on the firm until it remediates them [deficiencies]. The prudential requirements may include more stringent capital, leverage, or liquidity requirements, as well as restrictions on growth, activities, or operations of the firm, or its subsidiaries.”  If two years later, the firm has still failed to remediate the deficiencies, “the agencies, in consultation with the FSOC, may jointly require the firm to divest certain assets or operations to facilitate an orderly resolution of the firm in bankruptcy.”

The reality is that regulators are unlikely to use the resolution plan process to break up big banks.  This would require an unprecedented level of aggressiveness by the regulators and an atypical level of cooperation between the Federal Reserve and FDIC.  When the agencies first provided feedback on resolution plans in 2014, the FDIC Board of Directors found all 11 plans submitted to be not credible, while the Fed stopped short of such a designation for any firm.  More agreement was found in the most recent round of feedback provided in April, with the agencies agreeing on the status of six of the eight submitted plans.  However, the odds of both agencies agreeing on every joint assessment that must be made in order for divestitures to occur are slim to none.

To most Americans who are deeply disturbed by what went on within Wells Fargo, Rep. Waters conclusion that the firm is too big to manage rings true.  But rather than expend energy pursuing legislation to break up the bank, which has little chance of success, she and other lawmakers would be better served by focusing on the tools that Congress has already given regulators to accomplish this objective.  This may not lead to a smaller Wells Fargo, but it should lead to a better managed Wells Fargo, and a bank whose failure would not be catastrophic to our financial system.





[1] Six of the eight U.S. G-SIBs described their 2015 living wills as “single point of entry” (SPOE) strategies, whereby only the parent holding company files for reorganization under the bankruptcy code.  Subsidiaries continue to operate, are sold, or are wound down outside bankruptcy proceedings.  In Bank of New York Mellon Corp.’s plan, its depository institution and its affiliates would be resolved through FDIC receivership, while the company’s broker-dealer, asset manager, and other entities would be sold or would file for bankruptcy.

[2] The FDIC has this authority via the Federal Deposit Insurance Act.

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