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Living will deficiencies put too big to fail back in the spotlight

Mining Exploration Insights – February 2020

Mining by the Numbers — Canada in 2020

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Living will deficiencies put too big to fail back in the spotlight

Regulatorsescalated their living will evaluations with a joint finding that the plans of fivebanks were not credible, launching a process that could materially impact earnings.However, analyst and investor reaction was mild as it appears many expect banksto fix their plans.

The FederalReserve and the FDIC jointly deemed the living wills of JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co., StateStreet Corp. and Bankof New York Mellon Corp. to be notcredible, starting a process that could allow regulators to force thebanks to sell certain assets or entire operations.

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By issuinga joint determination, regulators can enforce enhanced prudential requirements ifthe banks fail to fix the deficiencies by an Oct. 1 deadline. For example, regulatorscould increase capital requirements, forbid certain types of activities or limita bank's growth rate. If regulators do that, a two-year clock starts, at the endof which regulators could force divestiture of bank assets, assuming the banks havestill not adequately remediated their living wills.

"Thisreally moves us to a new stage in the process, and it wasn't clear that regulatorswere willing to go there," said Justin Schardin, acting director of the financialregulatory reform initiative for the Bipartisan Policy Center. "It's unchartedterritory."

Schardinsaid the joint "not credible" designation will further fuel the debatearound too big to fail. The topic has received renewed attention in recent monthsas Neel Kashkari, the new president of the Federal Reserve Bank of Minneapolis,has launched an initiative to study the issue and deliver a plan by the end of 2016.

"It'sa topic that continues to be raised because you can't prove a negative," Schardinsaid. "No one will know for sure whether Dodd-Frank has fixed too big to failuntil we get to the next crisis."

The Fedand FDIC did not object to CitigroupInc.'s living will, although shortcomings were still identified.The regulators jointly identifiedweaknesses in plans from Goldman SachsGroup Inc. and MorganStanley, but did not make joint determinations regarding the plans andtheir deficiencies.

Regulatoryfeedback varied significantly from bank to bank, so it seems possible some bankswill be able to meet the Oct. 1 deadline while others will not. In a research note,bank analysts at Keefe Bruyette & Woods pegged State Street and Bank of NewYork Mellon as the two entities most damaged by the "not credible" designation.

"Weview the failing grade for [State Street] and [Bank of New York Mellon] as mostconcerning given the Fed seemed to have fundamental issues with the banks' plans,"the analysts wrote. Further, the analysts pointed out that the two banks have lowerexpenses, so an increase in regulatory costs will hit them harder than it wouldthe larger banks.

Ultimately,the KBW analysts wrote that they expect all banks to have remediation plans readyby Oct. 1 and have credible living wills by the 2017 submission deadline.

The deficienciesidentified by regulators ranged from liquidity management to governance controlsto legal entities organization. Some of those are difficult problems to addressin a short time frame, but the banks might not need a comprehensive fix, said JohnCorston, an independent senior adviser for Deloitte & Touche LLP and a formerFDIC associate director involved in resolution planning.

"Someof these things are not going to be fixed in five months," Corston said. "Butyou could have a plan to address the deficiencies, and you have to have the agenciesagree with your timing."

Investorsappeared unconcerned by news of the shortcomings in big bank living wills, as shareprices for all eight companies climbed in early trading April 13. By the close oftrading, Wells Fargo shares were up 2.64%, and shares for the other seven companieshad climbed more than 3%.

WellsFargo faces increased risk in its resubmission because its living will was foundto have material errors, the KBW analysts wrote. And the Bipartisan Policy Center'sSchardin said the "not credible" ruling for Wells Fargo was a considering the bank avoidedthis designation in the 2013 submissions. There were no joint determinations inthat round, but the FDIC did come to a "not credible" designation for11 banks not including Wells Fargo.

R. ScottSiefers, an analyst for Sandler O'Neill & Partners, also called the Wells Fargoruling a surprise considering the bank's history of strong regulatory compliance.But Siefers expects the bank to sufficiently address the concerns by the Oct. 1deadline. "We do not expect any near-term capital or businessmodel ramifications," he wrote.

Similarly,Deloitte's Corston said he does not expect regulators will need to force banks toadhere to enhanced prudential requirements such as higher capital ratios. If banksfail to address the issues by Oct. 1, Corston said banks will likely be proactive.

"Ifthere are still issues to address, I would expect the regulators to turn up theheat," Corston said. "They could take one of these [prudential requirements],but I would expect the firms to take action themselves."