(Bloomberg) -- Wall Street banks spent two years asking U.S. regulators what they should put in hypothetical bankruptcy plans to prove they arent too big to fail. The agencies broke their silence yesterday with a grade:Fail.
The Federal Reserve and Federal Deposit Insurance Corp. told 11 of the largest U.S. and foreign banks, including JPMorgan Chase & Co. and Goldman Sachs Group Inc., that they botched their so-called living wills. The agencies ordered the banks to simplify their legal structures and revise some practices to make sure they can collapse without damaging the wider financial system.
Its unfortunate that there have been public findings before there has been any substantive communications with the banks, said Rodgin Cohen, senior chairman at Sullivan & Cromwell LLP, which has several of the affected banks as clients.
The living-wills exercise was a key check on large banks written into the Dodd-Frank Act, a regulatory overhaul prompted by the 2008 financial crisis. Lehman Brothers Holdings Inc. provided the horror story for what happens when big, complex financial firms land in bankruptcy court. So the regulators yesterday directed the banks to take immediate action to make their holding companies easier to dismantle before their next round of annual filings in 2015.
The current plans demonstrate little ability to cope adequately with failure without some form of government support, FDIC Vice Chairman Thomas Hoenig said in a statement. The economy would almost surely go into crisis.
The FDIC officially deemed the 2013 plans not credible -- an important phrase under the law. Before 2015, the banks should develop a less complex legal structure and amend financial contracts, including for derivatives, to provide regulators more time to resolve a failing institution, the agencies said. They added that theyre willing to use Dodd-Frank powers to force changes if they have to.
The banks -- which also include Bank of America Corp., Morgan Stanley, Citigroup Inc., Deutsche Bank AG, Barclays Plc, Credit Suisse Group AG, UBS AG, State Street Corp. and Bank of New York Mellon Corp. -- were sent letters outlining specific deficiencies the agencies want them to fix.
The industry expressed irritation that the firms didnt get more direction from regulators before filing their most recent plans last month.
Financial institutions need clear and timely direction from the regulators, Alison Hawkins, a spokeswoman for the Washington-based Financial Services Roundtable, said in an e- mail. Financial companies have more capital and are stronger than before the crisis and want clear guidance to ensure they are meeting regulatory expectations.
Spokesmen for the individual banks declined to comment.
Already, banks have sold and shuttered businesses they deemed non-core, not profitable enough or which drew regulatory scrutiny. New York-based JPMorgan, the biggest U.S. bank by assets, agreed to sell its physical commodities unit for $3.5 billion in March. Charlotte, North Carolina-based Bank of America has sold stakes in Brazilian, Chinese and Mexican lenders and overseas credit-card and wealth-management units. European lenders including London-based Barclays and Zurich- based UBS have scaled back fixed-income operations.
Lawmakers have pressured the agencies to be tough.
Too Big to Fail is alive and well, Senator Sherrod Brown, a Democrat of Ohio, said in an e-mail. The FDICs statement that these living wills are not credible means that megabanks will live on taxpayer life support in the event of a crash.
At a congressional hearing last month, Senator Elizabeth Warren, a Massachusetts Democrat, pressed Fed Chair Janet Yellen to make the living wills convincing.
Can you honestly say that JPMorgan could be resolved in a rapid and orderly fashion as described in its plans with no threats to the economy and no need for a taxpayer bailout? Warren asked at the July 15 hearing.
I think what we need to do is to give them a road map for where we see obstacles to orderly resolution under the bankruptcy code, Yellen said in response.
Regulations already in the works may help fix some of the biggest shortcomings. The Fed is writing a rule to require banks hold a minimum amount of long-term debt at the parent company to absorb losses in a failure. The agencies have also been working with the International Swaps and Derivatives Association to revise swaps contracts to require trading partners to delay calling in collateral during a failure.
David Kass, a professor at the University of Marylands Robert H. Smith School of Business, said it would be best for the banks to make these changes voluntarily before they are forced to by the regulators.
This is potentially of major consequence to the banks if they fail to respond to these concerns, Kass said. Each bank receiving this letter needs to address each deficiency and do it in a way that is convincing.
Michael Krimminger, a former FDIC general counsel who represents banks at Cleary Gottlieb Steen & Hamilton LLP, pointed out a difference in language that he found important: Only the FDIC said the bankruptcy plans were not credible; the Fed only called for the companies to make changes and show them in the next plan.
Theres clearly a difference of view between the FDIC and the Federal Reserve, Krimminger said.
The Fed said its response is in keeping with a 2011 promise to let the process evolve without being overly aggressive about deficiencies.
"The board believes the joint letters of the board and the FDIC identifying shortcomings that must be addressed by the firms provide an effective way to improve the resolvability of firms," it said in a statement.
Krimminger said hes troubled that his former agency would fail the banks without having talked them through the process.
I wish thered been more chance for a dialogue with the regulators about that, he said in an interview. Maybe now itll happen.