Why banks should welcome “living wills”

September 15, 2009

A year after Lehman Brothers collapsed, policymakers are still getting to grips with the key question raised by the Wall Street firm’s fall: how to ensure that the failure of a large bank does not jeopardise the entire financial system.

After much debate, politicians and central bankers are warming to the idea that banks should make preparations for their own failure. This plan — memorably dubbed a “living will” by Mervyn King, governor of the Bank of England — would allow regulators to wind down even large, cross-border institutions without putting public money at risk.

Alistair Darling, Britain’s chancellor, wants to introduce legislation this autumn to force banks to draw up living wills. Such plans have drawn predictable squeals from bank executives, who claim the idea is hard to implement for large cross-border groups. They have a point. Nevertheless, bankers should embrace the idea, for the simple reason that it is better than any of the alternatives.

The status quo is no longer acceptable, so policymakers have three choices for dealing with large, systemically important financial institutions. The first is to make them smaller so that the collapse of any one bank would no longer threaten the system. The second option is to take a “zero failure” approach to regulation, along the lines of safety rules in the airline industry.

Both of these approaches have flaws. Small banks still pose a risk if they all collapse together. And preventing failures entirely would require a level of regulation that would stifle innovation and further reduce competition in financial services.

By contrast, a system of living wills would be far less intrusive. This is not to suggest the switch would be straightforward. Differences in national insolvency laws mean it is currently impossible to establish a consistent approach to winding up complex cross-border institutions. Politicians’ desire to protect local depositors and taxpayers — often at the expense of foreigners — also complicates matters. Simplifying corporate structures that have evolved over decades will also not be easy.

And even assuming that all these problems can be overcome, governments would still struggle to convince investors that they were really willing to use their powers.

Yet rather than resisting change, banks should welcome it. If the industry can come up with a credible mechanism that protects taxpayers from its mistakes, it can make a case for maintaining some commercial freedom. This may not be simple. But the alternatives are even less attractive.

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