Incentivizing Change in the Largest Financial Institutions

After writing this morning about the "living wills" required from large financial institutions via Dodd-Frank, I've read some additional information about the fact that the Federal Reserve and FDIC rejected five of them yesterday. I hope you'll stick with me and follow this trail of information. The topic is sure to come up in tonight's Democratic presidential debate and it's always good to be informed.

Senator Warren released a statement yesterday about the rejection of the living wills. Here is how she begins:

Today, after an extensive, multi-year review process, federal regulators concluded that five of the country's biggest banks are still - literally - Too Big to Fail. They officially determined that five US banks are large enough that any one of them could crash the economy again if they started to fail and were not bailed out.

Based on what I've read so far, that last sentence is a bit of an overstatement of what the federal regulators did yesterday. Matt Levine provides some very helpful clarification. First of all, he gives some examples of the issues the regulators found with the living wills. JP Morgan was faulted for providing cash flow projections for the first 7 days after filling bankruptcy and the last four - but not the days in between. If you've ever worked with federal regulators, this kind of thing will come as no surprise. But it hardly rises to the level of suggesting that JP Morgan would require a tax payer bail out should they go into bankruptcy.

Levine goes on to say that projecting this kind of detail for an unknown date in the future triggered by an unknown event is not going to lead to quantifiable procedures that would ever actually be implemented. So the question becomes: why require living wills in the first place? What purpose do they serve? I found his answer fascinating from the prospective of what it takes to change the culture of a huge organizational structure.

Levin suggests that what these regulations are designed to do is force these financial institutions to - as his title suggests - "think about death."

The great purpose of the living wills, it seems to me, is to re-focus banks' attention. It's to make sure that banks, at their most senior levels, are thinking deeply and carefully and critically about the things that regulators are worried about. It's to change how bankers think. The natural state of a chief executive officer is one of optimism, growth, aggressiveness. In the current regulatory environment, they are supposed to think a bit more about pessimism, decay, defensiveness. The living wills are a way to make them think sad, nervous thoughts -- and to punish them if they don't think those thoughts as rigorously as they should.

It is interesting to compare that to how banking regulations have typically worked (or not) in the past.

...much of the rest of the banking regulatory apparatus involve substituting the judgment of regulators for the judgment of bankers, at least to some extent. The bankers think that something is a good idea, the regulators think it's risky, and the regulators make banks cut it out, or at least make it more expensive for them to keep doing it. But this is a difficult game for the regulators to win, since the bankers will always be better paid, and better staffed and more motivated. It's hard for regulators to get into bankers' heads; the bankers can always stay a bit ahead.

Levine contrasts that with what these regulations are designed to do.

The new approach isn't (just) to have regulators second-guess bankers, though obviously there's a lot of second-guessing going on when seven out of eight banks get failing grades on their living wills. The new approach is to make the bankers get into the regulators' heads, to fill banks with people who spend so much time worrying about bankruptcy that those worries bleed into the banks' regular operations.

I have no idea if this is what lawmakers had in mind when they crafted the provisions of Dodd-Frank. But as a student of both human nature and effective management, this is a much more effective way to incentivize structural change.