WASHINGTON — The "living wills" process just got real.

More than two years after banks began drafting resolution plans, the Federal Reserve Board and Federal Deposit Insurance Corp. this week gave the 11 most complex institutions failing grades. In their first public feedback on banks' progress plotting their wind-downs, they found "shortcomings" for all 11, ordering banks to make significant changes in July 2015 or face regulatory consequences.

The two agencies warned that failure to make necessary improvements in next year's plans could result in their living wills being deemed "not credible," a formal determination mandated by the Dodd-Frank Act that would raise the stakes more. Ultimately, regulators could force an institution to face higher capital requirements or make divestitures.

The latest development has sparked pivotal questions about how the process moves from here, including what banks must do over the next year to improve their wills to avoid repercussions.

Here are four key takeaways from the regulators' actions:

It was a "damning" assessment
The statement by the Fed and FDIC indicated an across-the-board failure by the 11 banks to satisfy the regulators' standards for credible plans. Some improvements in the plans from their inaugural 2012 filings "notwithstanding, the agencies have jointly identified specific shortcomings with the 2013 resolution plans that will need to be addressed in the 2015 submissions," the Fed and FDIC said in a joint press release issued late Tuesday.

One of the flaws the Fed and FDIC mentioned were "assumptions" about what would transpire in a failure "that the agencies regard as unrealistic or inadequately supported."

That was a "key and relatively damning agency observation," said Kevin Petrasic, a partner at Paul Hastings. "This pretty much spells out a process that, in the regulators' view, suggests that the banks dramatically undershot the target. This is a fairly significant disconnect to be highlighting two years after the first wave of filers filed their initial plans, suggesting either the regulators were not very clear about their expectations or the banks were just not listening."

Dodd-Frank essentially offered two routes to avoid the contagion that followed failures of giant companies in 2008. The law, in Title II, gave the FDIC special powers to resolve failed behemoths in a manner that avoids systemic contagion. But, in the hopes that such powers are never needed, Title I required the living wills to prod banks to become simpler to unwind in a traditional bankruptcy.

In their statement, the regulators listed actions the 11 banks must demonstrate they are taking in their 2015 plans. They included establishing simpler legal and holding company structures to facilitate a smoother wind-down. The banks should also revise financial contracts to provide for the stay of counterparties' early termination rights, and demonstrate "operational capabilities" to be ready for a resolution.

Arthur Murton, who runs the FDIC's Office of Complex Financial Institutions, suggested that some of the required actions mentioned by regulators should not have come as a surprise to the banks.

He noted instances in which officials expressed their expectations, including 2013 guidance — issued after the first wave banks had submitted 2012 plans — providing instructions to filers, as well as a recent FDIC advisory committee meeting outlining details of what is needed in a Title I resolution.

Both "laid out pretty clearly in a public forum what a challenging standard it is to have these firms resolved under bankruptcy," Murton said.

Still, those expectations are now clearer
Despite the negative assessment, observers agreed that the release of the agencies' feedback — which had previously been a key missing ingredient in the process — gave banks crucial intelligence to understand what regulators want in the plans.

The regulators "set the bar in a new place. They've said, 'We want you to meet the bar and we're not going to reset the bar after this,'" said Oliver Ireland, a partner at Morrison Foerster.

Others said the feedback, including the steps regulators have called for in the 2015 plans, in some instances gives the banks license to institute changes to their wind-down plans they have already discussed.

"There is no question that without feedback from the regulators, it was hard to justify … difficult decisions when you did not know how those would be viewed," said Michael Krimminger, the FDIC's former general counsel and now a partner at Cleary Gottlieb Steen & Hamilton LLP.

He said he expects the banks and regulators to have more dialogue over the next year as the firms attempt improvements.

"The things that they are being asked to do are things they will be talking with the regulators about a lot," Krimminger said. "The joint statement … said that agency officials will be working with the companies in order to talk through how to improve their resolvability. From the companies' perspective, that's a big positive because they've been looking for that kind of dialogue.

"The worst thing that could have happened was to make this statement public and then not talk with the companies."

Rob Nichols, chief executive of the Financial Services Forum, agreed that the feedback is important, saying in a statement that "the industry not only welcomes, but also needs comprehensive and substantive feedback from the regulators on" living wills.

Murton said the regulators and banks are still in the process of developing a "new process" for living wills that did not exist prior to Dodd-Frank.

"It's new to the firms, it's new to the regulators," he said. "With any new process, there is some learning. We and the Fed worked very diligently together to try and provide meaningful and constructive feedback to the firms."

Regulators opted for candor — over sugarcoating — in their message
Arguably the most surprising thing about this week's announcement was the regulators' bluntness in highlighting the plans' weaknesses.

With banks hearing nothing on their 2013 plans for months, it was unclear how direct the agencies would end up being. (The first-wave filers submitted their 2014 plans in July without having heard any feedback on the 2013 plans.)

The statement indicated the agencies disagreed somewhat on how to proceed. The FDIC board voted to impose the "not credible" determination for all 11 plans, but needed the Fed to sign on for it to be binding. The two agencies ultimately agreed to give the banks another year to improve. But Thomas Hoenig, the FDIC's No. 2, went so far as to say in his own statement that despite encompassing "thousands of pages, … the plans provide no credible or clear path through bankruptcy that doesn't require unrealistic assumptions and direct or indirect public support."

Krimminger said that "guidance has been what the companies have been asking for and expecting for the last two years. It has not been coming.

"The surprising aspect of it is the severity of the message and the fact that the FDIC made clear that its board had concluded that the plans were not credible," he added.

But although the Fed did not go as far, the central bank did not pull many punches either. A separate statement from Fed board members conveyed their criticism prominently, saying, for example, that the banks "must take meaningful action" to improve plans and that the 2013 drafts "reflected important shortcomings in [the banks'] resolution planning efforts."

Some commentators lauded the agencies for holding firm.

Mike Konczal, a fellow at the Roosevelt Institute, said it is gratifying to see the regulators take the living wills process seriously. Ideally, he said, banks should be positioned for a traditional bankruptcy, instead of relying on the FDIC's special powers to manage wind-downs through a government facility.

"It's fantastic. It's a strong and encouraging sign," said Konczal, who writes the Rortybomb blog. "There is always a lot of doubt about these banks being able to go through bankruptcy in a way that doesn't cause a lot of problems. … It's good to see the regulators hold the line at bankruptcy and Title I as the first and main line of defense."

The regulators, he added, "could have papered over" the issue, "held their breath and just hoped that it all worked out. But they're putting it on the line to say they know there is a problem here."

Banks still have years before penalties could kick in
If there is any silver lining for the 11 banks, it is that any serious consequences resulting from the agencies' criticism are still likely a long way into the future.

The process laid out by Dodd-Frank includes multiple steps between the initial deficiency notice and the worst-case scenario — the agencies requiring divestitures — and the back-and-forth would likely be drawn out.

If a bank's 2015 plan is deemed "not credible," the institution will have to resubmit its plan with revisions to correct deficiencies, with the regulators setting the deadline. If regulators are still not satisfied after that point, they can impose tougher capital, leverage or liquidity requirements — as well as limits on growth and activities — until the bank presents a satisfactory plan. Then, if the institution still has not sufficiently revised its living will, the two agencies — after consulting with the Financial Stability Oversight Council — can force the bank to divest assets or operations to make the institution more resolvable under bankruptcy.

It is unclear exactly how long it would take before such divestitures became a reality, but Dodd-Frank suggests a multiyear process. In a June interview, Hoenig said it could take as long as four years from when the bank's plan is formally criticized for serious repercussions to take place, and that is assuming the plan is not corrected in that time. "Congress knew that they want it to take time," he said.

And since the regulators stopped short of issuing the "not credible" label, the banks no doubt will be working over the next year to avoid it altogether.

"The good news for the banks is that they have almost a year — to July 1, 2015 — to make the improvements that the regulators are looking for to address the deficiencies noted" in their joint statement, said Petrasic.

Joe Adler is the Deputy Washington Bureau Chief for American Banker

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