The Federal Reserve and the FDIC are coming down hard on the largest banks for submitting irresponsible contingency plans to avert another financial and economic cataclysm if they need to cease operation.
The primary purpose of the Dodd-Frank financial legislation was to ensure the soundness of the banking system and eliminate the need for public subsidies of banks that fail in the future.
That promise does not look promising at the moment.
In the past, banks believed their activities sustain the entire economy, and as such, they are entitled to taxpayer subsidies if they suffer severe financial losses due to poor risk management.
Dodd-Frank was crafted to negate this possibility in the future. This scenario is based on the premise that banks need to take responsibility for their own actions. Future losses incurred by a bank should be borne by shareholders, bondholders and management in the form of reduced asset values, lower compensation and financial restitution if illegal or unethical conduct transpired. Bank penalties can be amortized over many years to prevent closure and mass layoffs.
To ensure an orderly bankruptcy process, the large banks are periodically required to submit contingency plans that detail an orderly termination of their activity without inflicting catastrophic and systematic economic harm to the country.
The 2013 submissions were deemed wholly inadequate by the Federal Reserve and the FDIC.
The shortcomings included overly optimistic assumptions, inadequate planning and an implicit reliance on direct or indirect public support.
The analysis was conducted on banks with assets greater than $250 billion. They include Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and the U.S. units of Barclays, Credit Suisse, Deutsche Bank and USB.
The regulators have asked the banks to rethink and resubmit new plans that incorporate the following assumptions and parameters: 1) expect foreign regulators to seize assets, branches and subsidiaries of U.S. parent companies to prevent capital outflows that undermine foreign creditors, 2) permit early termination of derivative contracts by counterparties if leverage ratios are too high and insufficient collateral has been pledged to offset potential losses, 3) provide accurate and transparent internal reporting systems to verify the ownership and availability of adequate collateral and 4) forced divestitures may occur if complex legal entities are not simplified and liquidity and reserves are not increased.
Why would these banks all submit contingency plans that essentially permit activities that caused the financial crisis and would not thwart future catastrophes?
The possibilities include the following: 1) the banks do not believe their business methodology is potentially harmful to the general economy, 2) the banks would like to continue with business as usual if possible and 3) the banks are confident that the regulators will not police or enforce any restrictions placed on the banks.
The real test will come in July 2015, when the analyses of the 2014 plans, which have been submitted, are released. But questions remain. Will the Federal Reserve and the FDIC begin to dismantle these entities if poor plans are presented? More troublesome, will inadequate plans be accepted nevertheless by these regulators?
Sound monetary policy from Janet Yellen and the Fed
is predicated on strong confidence in the banking system. Monetary intervention coupled with an unstable banking environment may actually exacerbate our economic maladies.
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