Last Wednesday, regulators told the top three U.S. banks, "Sorry, but you're still too big to fail." Both the Federal Reserve and the FDIC deemed that the resolution plans in case of another financial collapse submitted by Bank of America Corp. (NYSE:BAC), JPMorgan Chase & Co. (NYSE:JPM), and Wells Fargo & Co (NYSE:WFC) were "not credible and would not facilitate an orderly resolution."
A resolution plan, or "living will," is meant to reassure regulators that a bank is able to wind down its operations without destabilizing the financial system. The regulators identified deficiencies in several areas, including the following three (I'll use "regulators" as shorthand for the Federal Reserve and the FDIC).
Liquidity management: Keep it flowing
As witnessed during the financial crisis at Bear Stearns and Lehman Brothers, being able to manage one's day-to-liquidity during a period of financial stress is the difference between being going back to work the next day or leaving with your personal effects in a box.
Yet regulators found that Bank of America and JPMorgan Chase lacked adequate models and processes to track liquidity at their "material entities" -- i.e., significant subsidiaries and foreign offices.
Governance: When do we do what?
Regulators cited deficiencies in governance at all three banks. For example, B of A's strategy to wind itself down is to recapitalize its material entities, with only the holding company entering bankruptcy proceedings. All well and good, but regulators found that the bank had not established any "triggers" that would link the capital and funding needs to the decision to file for bankruptcy protection.
Meanwhile, regulators suggested that a statement from JPMorgan's plan (which, curiously, they redacted in the reply) "raises questions as to how whether the directors would obtain information about the firm's condition in a timely manner." That sounds like a legitimate problem to me.
Derivatives and trading activities: shuffling, shuffling
Billionaire investor Warren Buffett famously called derivatives "weapons of financial mass destruction," so perhaps it's not surprising that they should come up as an area of concern in a resolution scenario.
According to data from the Office of the Comptroller of the Currency, with nearly $51 trillion in notional amounts of total derivatives, JPMorgan is the largest derivatives dealer in the United States. It's also the only bank of the three that regulators wrote up for deficiencies in this area.
Specifically, the bank's plan didn't explain how it would shrink the trading portfolios within its subsidiaries "in an orderly manner" if other market participants ceased to trade with them. Instead, the plan relied too heavily on the notion that if the subsidiaries were to receive adequate liquidity and capital, everything would go smoothly. That sounds like an elephant of an assumption.
(Incidentally, it may surprise you to learn that Citigroup is the No. 2 derivatives dealer, with a trading book that is only fractionally smaller than JPMorgan's, at $50.4 trillion versus $50.6 trillion.)
What we didn't see coming
Broadly speaking, the regulator's assessment of banks' living wills turned up a few surprises: The fact that JPMorgan and Wells Fargo, which are considered to be among the best-managed banks in the world, were both cited for deficiencies in terms of their governance, for example.
Of course, the biggest surprise of all is that Citigroup was the only bank out of eight to receive a qualified pass from both regulators; the bank's stock rose 5.6% on Wednesday. That suggests the market was underestimating the scale of the restructuring at an institution that investors left for dead in the financial crisis. That may still be the case today.
Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short May 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.