I suppose I should say something about "living wills," since the idea doesn't seem to be going away. It's hard to critique the idea, since no one seems to be willing to define living wills. The Dodd bill simply requires financial institutions to periodically submit:
[A plan] for rapid and orderly resolution in the event of material financial distress or failure.Clear as mud. Thanks guys. In any event, there are really two arguments I want to make regarding living wills, so I'm going to split this into two posts: one on what living wills can't do, and one on what living wills can do.
What Living Wills Can't Do
I think it's a bad idea to rely on the financial institution to submit a plan for their own resolution. Resolving failed financial institutions is something that regulators do; it's not something that financial institutions do.
The problem is that the form of the resolution, the cost to the resolution fund, and the damage to the financial system all depend critically on the potential buyers. Who the potential buyers will be, and how much they'll be willing to pay, is inherently unknowable in advance. Think about how much less damage Lehman's failure would have caused had there been a buyer — that is, had the FSA allowed Barclays to buy Lehman, with the Street-financed consortium eating the losses on $60bn of Lehman's worst assets. Without Barclays though, there was no buyer, and the overall cost of resolving Lehman skyrocketed. But who could have known in advance that there would be no buyer when the time came? Put another way, had Lehman submitted a living will saying that if it ran into trouble, it would sell itself to another major bank, with a Street-financed consortium sweetening the deal by eating the losses on Lehman's worst assets (i.e., an LTCM-like solution), would any regulator have rejected that living will? Of course not — because in truth, it wouldn't have been an unreasonable plan. But when it came down to it, Lehman's living will would've been useless. And now we're right back where we started.
Moreover, you can guarantee that any resolution plan that a financial institution submits will be excessively rosy/optimistic. The problem, again, is that everything depends on valuations. For example, one component of any resolution plan will necessarily be a plan to liquidate a portion of the institution's inventory of liquid assets. But what assets will be liquid in a period of financial stress, and how much will those assets fetch? Your guess is as good as mine. But what regulator could possibly have enough market knowledge/experience to challenge the financial institution on its valuations?
For the sake of argument, let's say a financial institution plans as part of its living will to liquidate half of its Agency MBS position to raise cash, and estimates that it can get ~90 cents on the dollar for half its Agency MBS position in a period of financial stress (these numbers are purely illustrative). When the financial institution meets with the Fed and FDIC officials to review its resolution plan, do you think there's any way that any Fed or FDIC official could seriously argue valuations with the financial institution's head MBS trader? Of course not. The trader undoubtedly knows infinitely more about his market than any of the regulators, whose jobs, while important, are most assuredly not to be experts on MBS valuations. So the regulators would ultimately have to accept the financial institution's valuations.
The same argument holds for divestitures as well — regulators wouldn't have been able to seriously challenge AIG's valuation for its ILFC subsidiary, because at the time of AIG's failure, everyone legitimately thought ILFC would fetch top dollar. Again, it all depends on who the buyers would be in a period of financial stress (Warren Buffett? Some sovereign wealth fund? Metlife?), and how much they would be willing to pony up.