Remember back in 2008 when many big banks nearly failed and threatened to bring the entire world with them? The government stepped in and rescued the financial system, but vowed to never again face a situation where firms were too big or interconnected to fail. The most significant effort to prevent this problem in the future was the creation of the new non-bank resolution authority, through last summer's financial regulation bill. Now, even big financial firms should be able to fail, as the Federal Deposit Insurance Corporation is developing the capability to wind them down quickly without destroying the rest of the economy. This will impose a cost on banks, but that's okay.
The challenge that banks will face is proving that they can fail. They must write up "living wills," which will provide a road map to regulators for winding them down if they collapse. Last week, Dave Clarke at Reuters reported on FDIC Chair Sheila Bair explaining that banks might have to change a little to complete these plans:
She said some large banks will probably have to make structural changes so that regulators can break them up if they are failing and seized by the government.
"If they can't show they can be resolved in a bankruptcy like process.. then they should be downsized now," she said.
There are two points to make here.
First, it's common for banks to complain about regulations that impose costs and changes on them. Some of those complaints are legitimate. Any complaints about complying with living wills, however, should be ignored. Regulators' decision to create a resolution authority and to require these failure plans was a generous gift to big banks. The alternative would have been to break them up as the default response. Instead, regulators decided to provide them with the opportunity to prove that they can exist without being too big to fail. So the burden of proof is on banks, and their living wills will be evidence that they won't need a bailout again.
Second, some big banks were staunch advocates for this plan. Perhaps the most vocal banker in favor of the new resolution authority was the CEO of JP Morgan, Jamie Dimon. He even went so far as to write an op-ed in the Washington Post arguing for its creation. To be sure, he didn't want his bank broken up. The resolution authority is something big banks asked for, so now they must make any necessary changes to allow it to work.
There's still some reason to be skeptical that the non-bank resolution authority will work as advertised, however. If several large financial firms are on the verge of collapse simultaneously, it's hard to imagine how all the planning in the world would help. But for now, it's the best idea we've got, as it's unclear if even breaking up the banks would have helped. Without the cooperation of banks, however, the new resolution authority doesn't have a chance at being effective.