Understanding Living Wills

During the recent financial crisis of 2007-08, several large financial institutions came close to failing. This led to a number of publicly supported rescues and other interventions involving taxpayer money. (1) In almost all of these instances, not intervening to lessen the impact of the failures on the market seemed (to some policymakers, at least) too costly. In other words, the crisis put into use the safety net for financial institutions. Ever since, fixing the so-called "too big to fail" (TBTF) problem has been a priority for policymakers.

The TBTF problem arises when a large financial institution is in financial distress: Policymakers are not generally able to commit not to rescue it from failing, mainly because of the fear of a sizeable disruption for financial markets and the economy as a whole if such a firm fails. This "ex-post" intervention of policymakers to prevent the failure, which effectively allows creditors of the firm in distress to avoid losses on their loans, implies perverse incentives for all large financial firms "ex ante": Because creditors anticipate no losses even in the event of failure, they do not make the price of their debt reflect the level of risk taken by the financial institutions. This may lead to excessive risk-taking by the firms, which in turn will mean more frequent failures, as well as more redistribution in the form of bailouts financed by taxpayers. (2)

In this article we will study how the requirement for large financial institutions to file resolution plans, or "living wills," with their regulators may help mitigate this commitment problem and, while doing so, decrease both the frequency of failures and their negative consequences for the economy when they do happen. A living will (LW) is a document that describes how a firm would be wound down through an unassisted bankruptcy procedure in the event of financial distress in an orderly fashion and with minimal impact to the rest of the economy. Living wills are a new requirement put in place as part of the 2010 Wall Street Reform Act, also known as the Dodd-Frank Act (DFA). The DFA was crafted with the objective of preventing financial crises like the recent one from happening in the future. As part of a wide reform of financial firm regulation, DFA prescribed a range of both new and strengthened requirements and procedures that added to the portfolio of tools with which the financial firms' supervisors work to ensure a strong financial system. Two prominent examples of existing tools that were reinforced in DFA are capital and liquidity requirements. Two important examples of new tools, which we will analyze in this article, are the requirement for systemically important financial institutions (SIFIs) to file living wills annually with their regulators and the provisions for the Orderly Liquidation Authority (OLA).

The OLA provisions, described in Title II of the Act, authorize the Federal Deposit Insurance Corporation (FDIC) to manage the winding down of certain troubled financial firms. The possibility of resolution under OLA was created by DFA as an alternative to bankruptcy, in recognition of the difficulties that may arise when using bankruptcy to resolve these very large, complex, and interconnected SIFIs. Before 2010, if a financial firm was deemed insolvent or undercapitalized and was not able to attract new capital, negotiate a bail-in by its creditors, or find a buyer in the market, it had to resort to bankruptcy. If debtor-in-possession (DIP) financing for a reorganization under Chapter 11 was not available in the market, the firm was forced into liquidation under Chapter 7. If policymakers viewed bankruptcy as too costly an alternative for society, they had options to provide public support through a purchase and acquisition of selected assets of the troubled institution (usually mediated by the FDIC if they involved depository institutions, possibly with explicit assistance in the form of asset guarantees), or a taxpayer-funded bailout that injected capital or guaranteed a loan with favorable terms. OLA constitutes a new alternative in which the firm does get reorganized and liquidated, but in a more orderly and efficient manner than through bankruptcy.

Although the details of resolution through OLA are still not clear (it has never been used so far), it has been pointed out that this alternative may be convenient in times of aggregate financial distress: It allows the FDIC to borrow from the Orderly Liquidation Fund (OLF), a dedicated account at the Treasury, at low interest rates to finance the operations of the firm in distress for at least some time. The availability of these cheap funds is likely to increase the liquidation value of the firm and possibly decrease the disruptions to the market, even in situations in which otherwise necessary DIP financing would not be available. If the liquidation of the distressed firm does not provide enough resources to repay the loans from the Treasury, DFA gives authority to charge fees on the solvent SIFIs to cover the difference, so no taxpayer money is used in OLA. However, it has also been pointed out that the availability of interim funding may benefit creditors that would otherwise get hurt from a sudden liquidation, hence leaving at least some of the perverse incentives of the TBTF problem in place. (3)

Despite the creation of the OLA, DFA still establishes bankruptcy as the preferred option for resolving a SIFI that is in financial difficulties. In order to make bankruptcy a more viable and orderly alternative, DFA requires firms designated as SIFIs to file an LW annually. Resolution through bankruptcy will be more orderly, for example, if it is easy to sell subsidiaries that are in good financial health to interested third parties. This is easiest when legal hurdles are minimal and these subsidiaries do not strongly depend on services (such as IT support) provided by other parts of the firm. As another example, resolution is easier when the failing firm has access to interim financing to keep its core operations working, which adds value to the firm. These examples suggest that a good LW should, among other things, describe the complementarities between assets and economies of scope across subsidiaries and provide a clear description of financing needs. This information would be helpful in maximizing the value of the company in bankruptcy.

Regulators review these LWs and require them to be useful and realistic. Moreover, if the plan for resolution makes apparent that certain characteristics of the firm complicate its liquidation, making the plan for liquidation "noncredible," regulators can require changes to those characteristics.

Living wills are a new tool, and regulators are still in the initial stages of implementing this requirement. Over the last few years, supervisors have been learning together with the firms about the key information that needs to be included in these documents. In this article, rather than providing a detailed description of the provisions in DFA relating to LWs and resolution, we want to lay down a framework that will help us understand LWs. Our objective is to study the potential benefits that LWs could bring to the regulation of financial firms, and the most useful ways in which the recently installed LW review process should evolve.

In our analysis, we will emphasize the two channels through which LWs should be useful. The first channel is their annual review process, which takes place in the ex-ante world. During this review process regulators are allowed to demand changes in the way that firms are conducting business (such as their size, or the number and level of interconnectedness of their subsidiaries) if they assess that these changes would make their potential resolution less disruptive for the economy. The second channel is through their role as "road maps" for resolution authorities (bankruptcy judges but also regulators if OLA is invoked) in the event of failure. That is, in the ex-post world, LWs indicate the most efficient way to resolve the firm with minimal impact on the market.

We will illustrate in the context of a simple model of the TBTF problem how regulating living wills (rejecting noncredible plans and, importantly, mandating changes that make them realistic) may change the ex-ante versus ex-post tension that leads to the TBTF problem, and hence change the severity of the moral hazard problem. We will ask the following questions: What are the properties of living wills that make them most useful as a commitment device and improve ex-ante welfare? Under what conditions are they more likely to bring about this improvement? What are the potential costs that regulators should consider?

Our work here complements recent work in DeYoung, Kowalik, and Reidhill (2013) and in White and Yorulmazer (2014). These articles also explicitly consider how different alternatives (or "technologies") for resolution affect welfare. White and Yorulmazer (2014) use a simple static model to present a review of the different interventions during the 2007-08 financial crisis. DeYoung, Kowalik, and Reidhill (2013) focus instead on the dynamic properties of the too-big-to-fail problem. They highlight that, as regulators get better at resolution, they can let large firms fail at less cost to society (i.e., they are willing to implement harsher punishments to these firms in equilibrium), which translates into less risk taken by firms, and hence less failures, being sustained in a Markov equilibrium of the repeated game.

1. FRAMEWORK

The time inconsistency problem that underlines the TBTF problem is best described by looking at the diagram in Figure 1. The diagram describes the three-period game between three players: (1) a financial firm that maximizes the expected profits of its shareholders, (2) the creditors of the firm who set the interest rate on their loans to the firm as to equate the expected return of debt and risk-free bonds, and (3) a benevolent policymaker, or "planner," who maximizes the welfare of society (i.e., the joint payoffs to the shareholders, the creditors, and the rest of society). The planner has a large budget funded by tax revenues to use in potential bailouts, as well as funds in the OLF from fees collected from financial institutions that can be used by the OLA to provide funding to wind down SIFIs in distress.

The characteristics of a firm will be summarized in a vector X, partitioned into a subset of characteristics [omega] over which the policymaker has control, and a subset x that is chosen freely by the firm:

X = ([omega], x).

Timing and Strategies

In period 0, the planner moves first and sets regulation, which will determine the constraints on a subset [omega] of the vector of characteristics X of the firm. This regulation includes capital and liquidity requirements, and the obligation to file LWs that meet the planner's standards. Choices of the firm such as size and complexity will only be in [omega] if LWs are regulated; that is, we model the increased regulatory powers given by the DFA with the LW review process as an expansion of the choices [omega] [subset] X over which supervisors have control.

In period 1, the firm chooses a subset of its characteristics, x, given that creditors choose a price R for loans that makes them indifferent between lending to the firm or buying riskless bonds, which pay an interest [[bar.R].sub.1].

In period 2, nature determines the realization of an economic shock, [theta] [member of] [THETA], according to the density function h, and a political shock, [epsilon] [member of] [epsilon], according to the density function g. The economic shock realization contains two elements, [theta] = ([[theta].sup.i], [[theta].sup.a]), where [[theta].sup.i] represents the idiosyncratic state of the individual firm, which affects the value and/or liquidity of its assets, and [[theta].sup.a] represents the aggregate state of the economy, which affects the cost of funding that the firm will face in case of distress in period 2, [[bar. …

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