Living wills make no sense: no bank can die in isolation

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I note that US regulators have rejected thirteen major bank's 'living wills', suggesting, according to the FT, that they are

deficient and fail to convincingly demonstrate how, in failure, any one of these firms could overcome obstacles to entering bankruptcy without precipitating a financial crisis.

The banks are apparently furious at this rejection of their plans, suggesting no adequate explanation has been offered by the regulators. For once I see an argument where it may well be true that both sides are right.

First of all, it's necessary to understand the logic of the living will. This is a plan that a bank is supposed to have in place that suggests how the bank could suffer a catastrophic event requiring its own liquidation that can be managed in a way that does not threaten the stability of the whole financial system.

Living wills are a nice idea, dreamed up, no doubt, by a banker to reassure politicians sometime around 2009 that systemic risk in the banking system could be managed if only each bank could be allowed to fail individually, which neoclassical economics and neoliberal thought demands that it should.

Unfortunately, the idea is also absurd. It assumes that catastrophic incidents impacting on banks' viability are independent events that only have consequence for one at a time. That is glaringly obviously not true. 2008 proved that. The fact that most banks provide almost identical products on almost identical terms to the same, largely similar, customers all of whom are subject to a similar range of unknown unknowns makes it glaringly obvious that the chance that catastrophic events impacting a particular bank's chance of survival are independent is minimal. Such events happen almost simultaneously across economies as a whole and impact the whole banking sector at the same time precisely because that sector has, like much activity hidden behind a veneer of competition in the modern economy, a near identical business model in each entity that makes it up.

The consequence is that regulators are demanding something from banks that is inherently unrealistic. Living wills are required to presume counter parties to banking contracts will survive the failure of a bank. The reality is that banks do not exist as independent entities. They exist only as part of a banking system that has been fairly arbitrarily differentiated into operating units under notionally different ownership but which system is, almost inevitably, in fact under largely consistent common ownership by the world's major investment funds.

In that case there can never be a meaningful living will for any one bank. They stand or fall together at the end of the day. Bankers may be perplexed by the regulator but the reality is that they should not be. They are all playing a game of charades designed to fool some politicians and rather more people beyond the limited circles of finance that current risk within the banking system can be mitigated by some rule changes. That is not possible. Systemic banking risk is real and continuing. Playing games to pretend otherwise is a fool's errand and that is beginning to become apparent.

We need real banking reform, not these silly games that achieve nothing and waste vast resources.