Living Wills for Dying Banks

Il “testamento in vita” (living will) di una banca è simile a quello di una persona, che stabilisce come comportarsi in caso di sua sopravvenuta incapacità fisica. Nel Regno Unito, la procedura fallimentare opera in modo soddisfacente per le imprese in genere, ma il caso Northern Rock ha messo in evidenza il problema dell’assenza di procedure concorsuali specifiche per le banche. Né, in quel caso, si è ritenuto di far fallire la N.R. e di attivare il credito di ultima istanza della banca centrale per prevenire il contagio dal suo fallimento. La sola soluzione praticabile è stata la sua nazionalizzazione. A seguito di ciò, il Regno Unito ha introdotto una normativa per la liquidazione coatta (Special Resolution Regime) degli istituti di deposito. Tale normativa però non si applica a istituti che non raccolgono depositi (banche d’investimento) e perplessità vi sono circa la sua applicabilità a grandi banche internazionali, per la complessità delle loro transazioni. I living wills, in tali casi, sono essenzialmente piani, concordati con l’organo di vigilanza, volti – tra l’altro – ad assegnare attività e passività a singole divisioni della banca, fornire elenchi delle controparti, dare spiegazioni sulle procedure di messa in sofferenza o cancellazione di attività, in modo che, in caso di crisi, sia resa possibile una tempestiva e ordinata “liquidazione”dell’istituto. Essi possono essere visti come un’alternativa a radicali proposte di separazione dell’attività bancaria da quella d’investimento.

“The sanction that capitalism imposes on imprudence, incompetence, sometimes just bad luck, is failure. It is the brooding presence of that sanction that keeps managers on their toes, that keeps them acting in a prudent way.”
(Lee Bucheit – Cleary Gottlieb Steen & Hamilton LLP – to the House of Lords Economic Affairs Committee, 2009)

The Living Will

The Governor of the Bank of England has recently advocated not only that banks be split up into utilities – those which provide basic payment system activities – and the rest. He has also urged, though, that banks be required to draw up “living wills”.  The Treasury Select Committee of the House of Commons has also recommended the idea. What are these wills? Why may they seem desirable? And are they preferable to splitting up banks?

The term “living will” comes from a development in English law relating to individuals and their well-being. When an individual dies, if they leave a will which is legal then whatever property they leave on death is disposed of according to their wishes, subject to taxes and any challenges from parties who think they were entitled to a bequest (or a bigger bequest). A “living will” does very much the same thing, but for an individual who although incapacitated is not dead. The “will” appoints “attorneys”, who can take decisions for the individual who can no longer do so, either according to instructions given in the “living will” or if discretion has been given then according to what they think best for the individual. These decisions can appertain either to medical treatment (including its withdrawal or withholding) or to financial matters, or both.

The idea is then that banks draw up an analogous document. Why has this idea taken hold, and what would the document do?

Earlier Problems

To continue with the analogy, when a company is declared bankrupt it has its affairs wound up under the bankruptcy code. This is analogous to the will of a person, except that every company has the same will; the order in which creditors are paid off, and the proportions if apportioning is necessary, are prescribed in law. This normally works well, giving a degree of certainty to commercial transactions by letting people know the risks they are exposed to if things go wrong with a company with which they are dealing. Changes were made to it over the years, but there was no questioning of whether it was an appropriate procedure for all kinds of company.

Then, in 2007, the banking system got into difficulties. In Britain this showed first in the struggles of Northern Rock, the mortgage lender. This bank was eventually nationalised, and there are now plans to break it up and sell off a part of it into private hands again[1]. Before its nationalisation several possible courses of action were considered. It might find a buyer; markets might revive to such an extent that it could once more be able to finance itself; or Northern Rock could receive a government guaranteed loan from the Bank of England. What is notable about that list is that the classic response to a failing bank is missing. Never considered was the possibility that Northern Rock be allowed to fail, with any resulting alarm prevented from spreading to the rest of the banking system by the kind of lender of last resort operation that had in the past, in Britain and elsewhere, prevented an individual bank failure turning into a widespread banking crisis.

Why was that classic policy not even considered? This question is examined in detail in Milne and Wood (2009) but an important factor was manifestly the problems that would follow a bank closure even if contagion were prevented.  Contracts would have been left unsettled for the length of the bankruptcy proceedings, and firms and individuals would have suffered from the sudden loss of banking services.[2] These were not such problems in the 19th century, when the lender of last resort concept was developed and used. And in the 20th century British banking had been so stable that no-one had noticed, or at least acted on if they did notice, the emergence of these difficulties.

No-one wished the only feasible response to a bank’s being close to insolvency being to nationalise it. The Treasury Select Committee of the House of Commons, in its report into the Northern Rock failure, recommended that there be a special insolvency regime for banks, so that they could be taken over before becoming technically insolvent, and run down in an orderly fashion, or sold off in whole or in part, just as they can be in the USA. This proposal was quickly adopted, and the technique has already been applied to a small building society which was in difficulty.

Why then is there call for a “living will” for banks? Given that banks can now have orderly funerals promptly conducted under the new legislation, why should they bother with “living wills”?

Large Banks

The existing legislation applies in principle to all commercial banks and building societies. It does not however cover investment banks even in principle, and while it does in principle cover large, complex, international banks, there are, surely correctly, doubts about whether it could be applied to them.

Why do these doubts arise?

There are doubts about the applicability of the current prompt closure procedure to investment banks simply because these banks are not deposit taking institutions, but rather institutions which arrange deals and act as counterparties in complex transactions. A very important aspect of the latter is shown by their role in structured products such as the fairly widely sold “guaranteed equity return” funds. These guarantee a minimum return from a portfolio in return for there being a cap on returns from the portfolio. The closure of Lehman’s has cast a good number of these products into jeopardy. Orderly closure along the lines of prompt corrective action would not help much here, nor would it help with, for example, holdings of credit default swaps.

International banks because they have assets and liabilities in many countries can if they face an emergency capital shortage call on many countries – which could mean that no country felt responsible.

And large banks could, quite simply, be beyond the capacity of the liquidators to understand and wind down in a reasonable period of time.

These are the problems “living wills” are designed to deal with.

What the Wills would do

Essentially, they would tell an outside how the bank worked. Of particular importance, they would clearly assign different assets and liabilities to different subdivisions of the bank. They would provide an accessible list of counterparties, and their associated transactions. They would clearly describe provisioning and write-off procedures that had been adopted in particular cases and were adopted as general rules. In short, just as a person’s living will lays out what should be done when he or she can no longer do it for themselves, so would a bank’s living will provide all the information needed for someone to intervene when it was in trouble and run it down (or otherwise dispose of it) in a prompt and orderly manner.

Why the Wills are Important

These living wills would thus be important in two ways. First, they would ensure that when some institution, however large or complex, got into difficulties, it could be handled without major collateral problems. That in itself is a good argument for them.

Second, and associated with that, these wills would make future crises less likely. For they would ensure that no bank was ever again “too big to fail”. The “brooding presence” of the risk of failure would once again make bankers act in a prudent way.

Alessandro Roselli: “A Comment”

If I understand correctly, living wills are proposed within a regulatory framework that, at the same time, would keep the present banking structures and avoid the too-big-to fail issue: an alternative to the radical proposal of splitting them.

Living wills would be useful for broker/dealers and for large international banks. The independent broker/dealers are – or were, before the (quasi) collapse of the big 5 – very relevant in the US, less, I think, in Europe, where the universal bank model is fully adopted. These are banks that have access to the lender of last resort. The problem of international banks is more an issue of coordinating supervisors than of knowing better their subdivisions, internal procedures and off-balance structures (which should in any case be known to the regulator).

To whom the living wills should be made known? Just to the regulator or also to the counterparties?

My guess is that living wills can help, but perhaps their relevance shouldn’t be overestimated.

Geoffrey Wood: “A Reply”

I am greatly indebted to Dr. Roselli for his thoughtful comments. There is little difference between us. This response is primarily for the sake of clarity.

Living wills in Europe are indeed primarily for large banks, and in Europe most of these are on the universal model. That they have access to a central bank as lender of last resort is indisputable. But central banks provide only liquidity. The provision of liquidity can not deal with fundamental insolvency, although it can prevent insolvency from arising through a bank’s having to sell assets into a thin and distressed market.

Living wills are designed to deal with a bank which is running out of capital. Co-ordination of supervision across national borders would undoubtedly give better warning of this than we have had recently, but it will not prevent it happening, nor remove the need for the orderly handling of a bank approaching insolvency. Living wills are designed to make this easier. They will not of course make it easy; Dr. Roselli is correct to emphasise that living wills can help in such difficulties, but not to the extent of removing them.

And finally, to whom should the detail of such wills be disclosed? Certainly to central banks and supervisors. It would be up to the banks involved to decide whether they should be disclosed more generally. In the 19th century in Britain banks started to disclose their capital ratios to build up public confidence in them. If it were thought that disclosure of the detail of living wills (their existence would be public knowledge since all banks over a certain size would have them) would build up confidence in the institution, by for example showing it to have an orderly management with clear organisational structure, then public disclosure might start to become the general practice.


1.  The possibility that it be turned into a mutually owned institution is being discussed also, but a normal commercial sale seems at the moment to be the government’s preferred option.

2.  In addition many individuals would have lost a portion of their deposits with Northern Rock, and this was politically unpalatable.