Does BP's Spill Show That Living Wills for Banks Are Doomed?

What did the financial crisis and the Gulf spill have in common? Arguably, both were at least partially caused by a failure of regulation. Congress is currently working on legislation which attempts to correct some of those problems in the financial industry. We can pretty easily assume that stronger oil drilling rules will also soon follow. One of the central new regulatory changes in the financial regulation bill would require so-called "living wills," which would be plans each big financial institutions submit to government regulators to explain how it could be wound down without disturbing the economy if it fails. But the oil disaster might show why these living wills won't help.

This argument is made today by economist Simon Johnson on the New York Times Economix blog. His reasoning boils down to three points. Here's my brief interpretation of each:

1. Regulators won't demand enough detail or exhibit the expertise to be sure that these plans will work.

2. Firms enjoy profits but push costs onto society, whether oil or financial. Thus, they won't have an incentive to develop good plans.

3. Politicians don't fear the wrath of the electorate if they go too easy on business, so lobbyists always win at shaping regulation in their favor. As a result, you have to cut out the risky activity like a cancer by prohibiting it. This goes for some kinds or oil drilling and large financial institutions.

Let's work backwards. His last point highlights a failure with democracy. By the time regulation is imposed it generally benefits the companies it attempts to rein in. But it can also be hazardous to outlaw activities or firms unless we can be absolutely certain that their harm outweigh their benefits. In terms of breaking up the banks, it's not certain that would help. If someone gets shot in the chest with birdshot, their fate may be the same as if buckshot was used. Similarly, hundreds of small banks failing could be just as dangerous as if ten big ones are on the brink.

On the second point, an argument here helps to explain how the government actually helped distort the oil companies' cost-benefit analyses by imposing a liability cap. From the financial industry standpoint, tweaking incentive pay could help with this problem, by better rewarding employees based on long-term profits instead of short-term gain. As for the living wills they develop, it's the regulators' job to make sure they're sufficient and workable.

And that brings us to his first point, which is probably the strongest. How can we know that regulators will ensure that living wills can work? After all, their track record is pretty bad for understanding the risks that industries, whether oil or financial, face. And it's not likely that we would ever be able (or want) to pay them more than Wall Street or oil company executives to get the better minds in the public sector.

But even if regulators imperfect, that doesn't mean living wills are a waste. They may still help matters. Regulators can also require the plans be put under stress tests to see if it's plausible that they would work in a financial crisis. The reality is that they probably won't all work all the time. But some may work some of the time. That might not be ideal, but it is progress.

So Johnson is right to worry that these living wills aren't a silver bullet for financial reform. But with that said, it's hard to see what harm they would do. They impose a relatively low burden on financial firms compared to other regulations, and there's a chance that they could help regulators when future economic shocks hit.