Why “Living Wills” Fail

A central idea in the financial reforms currently undergoing final negotiation in the United States – and also in similar initiatives in Europe – is that large banks must draw up “living wills” that should explain, in considerable detail, how they will be wound down in the event of future failure.

The concept is appealing in theory.  No one knows their business better than the banks, the reasoning goes, so they should have responsibility for explaining how they can close down their various operations – or perhaps sell more valuable parts while limiting losses for unprofitable activities.  This is often presented as “smart regulation”, with government regulators requiring private sector experts to do the difficult technical work.

Tuesday’s hearing of the House Energy and Commerce Committee shed considerable light on why living wills are highly unlikely to work in practice.  The hearing was actually about the oil industry – and its government-mandated plans to deal with oil spills.  The committee posted the spill response plans for the Gulf of Mexico of five companies – BP, Chevron, ConocoPhillips, Exxon Mobil, and Shell – which demonstrated striking, peculiar and disconcerting similarities.

The glossy covers and photos are different, but it turns out that all the plans were written by the same subcontractor.  All contain some goofy details – including how to protect walruses, sea lions, and seals, which don’t actually live in the Gulf.  More worrying, given the apparent and complete failure of the BP response at Deepwater Horizon, it appears that none of the major oil companies are more (or less) prepared for such events.

There are three ways to think about this problem in more general terms – across oil extraction, finance, and other sectors.

1) The regulators should have done a better job in demanding more detail.  But the technical expertise and the highly paid experts are concentrated in the private sector, not in government.  If you are willing to raise the salaries of regulators to levels competitive with Wall Street, then we can talk.  Otherwise, the regulators will have a hard time second guessing what the experts (and their lawyers) tell them.

2) The private sector should take this kind of risk more seriously.  Of course this makes sense – but their jobs (and thus their incentives) are about making money, not about protecting the environment or worrying about the social costs of a financial meltdown.  Limited time horizons are much more of an issue in finance than in oil exploration and drilling, but the asymmetry of payoffs is quite parallel – industry executives (and employees, to some extent, and sometimes shareholders) get the upside when everything goes well; the costs, when things go badly, are pushed off onto society.  It is completely unreasonable to expect that the private sector will do anything to fix these issues by itself – in fact, as soon as lobbying is politically acceptable again (not when there is maximum political anger, but soon after that dissipates), the oil industry will again be working all its back channels and providing political contributions that oppose tighter regulation.  This has definitely been the experience of big finance – in the dog house from September 2008 through spring 2009; but over the past 9 months, again one of the most powerful and well-heeled lobbies in the history of the American republic.

3) The highest levels of government need to decide what we should allow and not allow, in terms of the most risky activities.  In the most prescient book written about Too Big To Fail in banking, and the trouble that this would bring, Gary Stern and Ron Feldman argued – in the early part of the 2000s – that “penalizing policymakers” should be an important part of how we make credible any commitment not to support megabanks when they fail.  Put more bluntly, if you support such banks – you will face electoral consequences.  President Obama is now experiencing a form of backlash against years of regulatory capture – and against the pathetic nature of “living wills” for failed deep water oil wells.  If he is able to draw any more general lessons – and this remains far from clear – the president would be well advised to reflect on other activities that are simply so dangerous that our obvious and repeated regulatory weaknesses mean we would be better off simply prohibiting (e.g., some kinds of drilling or having big banks).  We can debate the case for various kinds of off-shore drilling, but the facts on big banks are cut and dried – there is no social benefit to having banks above $100 billion (total balance sheet), but we have allowed our largest banks to rise above $2 trillion and there is every indication that they will keep growing.

It is ironic that while President Obama has done just enough vis-à-vis financial reform to annoy big players who lend to hapless consumers (e.g., payday lenders, who charge incredibly high interest rates) – and to motivate them to oppose his agenda more broadly, he has not substantially addressed what creates so much system risk.

There was a simple and straightforward way to reduce the dangers posed by big banks – to make them smaller with a binding size cap.  No serious proponent of this idea argued that it was sufficient for financial stability but the existing and growing consensus is that this would have been completely complementary to other efforts to make regulation more effective, to limit the dangers posed by “financial interconnectedness”, to bring all derivatives onto exchanges, and so on.

But as the Treasury Department now brags to journalists, “If enacted, Brown-Kaufman [the Senate amendment to cap bank size] would have broken up the six biggest banks in America,” a senior Treasury official said. “If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.”

President Obama inherited many problems with regard to offshore drilling, and we have yet to see his full response with regard to the underlying issues of incentives and regulation – or how he will be evaluated, at the end of that day, by the electorate.  

But on Big Finance he has had ample opportunity to limit abusive corporate power and he always preferred instead “business as usual” and such illusions as “living wills”.

An edited version of this post appeared today on the NYT’s Economix.

Originally appeared at The Baseline Scenario and reproduced here with the author’s permission.