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Four Key Issues for Financial Institutions to Address in Their Living Wills

In November, Wells Fargo became the first U.S. bank to receive measured approval for its "living will," its plan for unwinding itself in the face of bankruptcy with minimal damage to the financial ecosystem. While identifying "specific shortcomings," the boards of the Federal Reserve and the Federal Deposit Insurance Corporation found that Wells Fargo's 2014 plan "provides a basis for a resolution strategy that could facilitate an orderly resolution under bankruptcy."

In the context of the agencies' unfavorable reviews of other banks last summer, the restrained approval of Wells Fargo's plan looks like a resounding victory. Back In August, the agencies handed all 11 of the largest US and foreign banks failing grades for their plans.

While the Fed and FDIC have been the agencies evaluating banks' living wills in the US, regulators across the globe are reviewing financial firms' resolution plans. Although the initial focus is mainly on large, systemically important institutions, the issues regulators are focusing on and the measures regulators view as essential to creating "credible" resolution plans offer lessons for financial institutions of all sizes. Here are four issues that top regulators' lists:

Legal entities – Atop the Fed and FDIC's list of complaints when it failed the living wills of 11 of the largest global banks last August was the complexity of the firms' corporate structures. The agencies called on firms to establish more rational legal structures that better aligned legal entities and business lines. JPMorgan for example, listed 35 "material entities" in its resolution plan, according to the portion of it available on the Fed Web site. That number may actually be modest considering that the bankruptcy of Lehman Brothers involved more than 100 separate insolvency proceedings,according to Weil, Gotshal & Manges, which served as the Chapter 11 bankruptcy attorneys for Lehman Brothers Holdings.

Beyond just reducing legal entities' numbers, rationalizing and better aligning legal entities can produce significant efficiency gains that can benefit financial firms when they are solvent, as well in bankruptcy,argues Charles Taylor, deputy comptroller, capital and regulatory policy, in the Office of the Comptroller of the Currency. Potential benefits include lowered legal, finance and accounting fees, but also the potential to integrate systems and consolidate vendor contracts, Taylor said.

Capital – One of the most obvious issues when considering potential bank or financial firm bankruptcies is capital ratios. As Thomas Hoenig, vice chairman of the FDIC, said in a speech last month,"No amount of equity capital can save an individual firm from the consequences of poor management. However, sufficient equity does enable good managers to survive errors in judgment and allows an industry to absorb the effects of a poorly managed firm's failure."

The Basel-based international regulator, the Financial Stability Board, proposed new buffers of total loss absorbing capital (TLAC) last month that would essentially double capital and leverage requirements, according to estimates by BBVA. The FSB proposal would create a buffer consisting of instruments that could be easily written down or converted into equity in the case of bankruptcy. It's still in early stages, but with Hoenig calling the lack of adequate capital one of the "greatest impediments to successful bankruptcy and resolution," firms may want to closely examine their capital levels in the context of prevailing proposals.

Shared Services –Another key action outlined by the Fed and FDIC when it failed resolution plans of the largest banks was that financial institutions must ensure "the continuity of shared services that support critical operations and core business lines."

The FSB defines shared services as activities or functions that are performed for counterparties, client organizations or for more than one legal entity within a group. The services can be performed by internal units, separate legal entities within a group, or external providers. Shared services need to be organized in a way that ensures continued availability to all who use them. For example, preparing in advance for a "carve out" of these services a crisis would be one way to ensure their availability, according to the FSB. A financial services firm may provide payments and payments processing services, for example, to its own clients or between its clients and others. The criticality of these shared services may depend on issues such as for how long the services can be delayed, and how easily the services can be transferred to other providers.

Information management –The Fed and FDIC are also emphasizing information management, saying banks need to demonstrate "operational capabilities for resolution preparedness, such as the ability to produce reliable information in a timely manner."

While there doesn't appear to be much public detail from the Fed and FDIC about information management requirements, the FSB devotes pages to it. Firms should be able to be able to demonstrate that they can produce essential information need to implement resolution plans in a short period of time, probably 24 hours, the FSB says. Firms should maintain information on a group level and a legal entity level, and they should be prepared to identify any legal constrains to sharing information between entities, or from entities to the parent company. They also need to have a detailed inventory of their management information systems (MIS) that describes the key MIS used by different entities as well as which core services and critical functions the MIS provides.

The FDIC's Hoenig calls the global financial system "the definition of concentrated risk" because of its interconnectedness. Living wills designed to effectively control that risk will likely grow in importance for many players in the financial industry. The FSB has already issued specific resolution guidelines tailored toward insurers and non-bank financial institutions, in addition to the traditional banking players. For regulators, these plans are increasingly viewed as critical to ensure that risks of interconnectedness are effectively managed.