By Simon Johnson
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. It is used here with permission and if you would like to reproduce the entire piece, please contact the New York Times.
29 thoughts on “Why “Living Wills” Fail”
Great – was waiting for a post like this. The more “free markets” you are, the more you should be willing to agree with pessimistic predictions in a system where regulators are paid a small fraction of those they’re trying to regulate, especially when doors are revolving faster then ever before…
Simon, I strongly disagree with your main point, that living wills don’t work in practice.
Your assumption is that all companies behave like the oil companies. While this behavior is common, particularly with large companies that have developed a degree of hubris, it is not always the case and more adequate regulatory supervision would make it even less so. I was in a big company that worked through crisis and disaster planning, driven by the experience of 9-11. Although I am sure the plans would have been found to have many, many shortcomings if and when a new crisis had occurred (you never see the lightning that strikes you), the process itself was taken very seriously and, for the first time, raised executive awareness to the nature of the risks and the procedures, communications and possible fault lines generated by the unexpected.
The plans submitted by the oil companies were an insulting farce, tolerated by an agency that made a joke of the whole system. But your second point is the one that makes sense–the private sector should be made to take these kinds of risk more seriously.
For all their faults, living wills, if properly prepared and supervised would, not be an “illusion.”
The idea of a “living will” presumes that the company writing the will (or the regulators watching it) can predict why and how fast the company will fail. If there is anything that the last several years has shown us it’s that such predictions are mostly futile. The problem lies in applying linear thinking to a fundamentally complex (non-linear) system. The only way to combat such systemic risk is to make the system (and the companies operating in it) much more resilient to such shocks. This almost always means that the system cannot be engineered for maximum efficiency with respect to first-order metrics but instead must incorporate multiple equivalent mechanisms that are not easily controllable in traditional ways, nor should they be. Local uncertainty will increase, but global and long-term robustness is reduced.
Given this essential obscurity, systems that depend upon macro measurement and control – including standard regulatory environments – ultimately will fail. It is the culture of the companies and people that work for them, the size of those companies, and their diversity of approach to the societal need they address that determines success or failure.
What would such a system look like? A lot more micro and a lot less macro. One could also argue that standardization and interconnectedness would need to be REDUCED to improve robustness, exactly the opposite of the general trends in all sectors over the last 20 years. This doesn’t mean that we can’t have a single TV or cell-phone standard – but that things like high-speed, network-based trading, risk mitigation outsourcing (to the same company!), and the like need to be discouraged. Somehow.
By ‘crisis and disaster planning driven by the experience of 9-11’, do you perhaps refer to protecting the executives from further terrorist attacks? I bet that process was taken seriously.
As these living wills are protecting the public from the executives, I expect it’s more like saving those walruses in the Gulf. Wouldn’t be surprised if they are all written by newly minted MBAs at McKinsey.
Or, to put the matter more concisely, make all the players significantly smaller, so that no matter how badly any of them f***s up nothing important really changes, except for them.
No we weren’t that cynical. Protecting employees, the company, the public and the payments system. I don’t have a problem with that. Oh, and by the way, by then we had learned not to rely on consultants for the process.
The problem in the case of BP, and perhaps also finance, is that a good plan may not be executed in the event of an emergency. Professionally, I’ve been involved in disaster response for many years. The problem is that people don’t always do what you want them to do in a disaster and other factors intrude that were not predicted.
It is similar to the reason why the military doesn’t just draw up a plan, or will, and say that we will do this in the event of conflict or war. They train all of the time, so that it is second nature in the event of something happening.
The only way, then, for a living will to work for any event, in oil or finance, would be if there were some way to constantly act it out so that the parties involved will know how to respond immediately and unforseen consequences may have cropped up.
. . but a smaller oil extraction company can cause more damage than it can pay for. Not the same as banks.
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.
I don’t buy this. Anyone not busy snorting meth off a toaster could have noticed the walruses, or the similarities between the different companies’ plans. Financial contingency plans are already being raked over the coals by bloggers. If regulators with full-time jobs can’t even see what blogs are seeing in their spare time, it’s because their eyes are closed, not because they lack technical expertise.
Higher regulator salaries might be nice, to make them more resistant to bribery for one thing, but they’re not necessary to generate some improvement — they just need to have the mindset that their regulatory role is useful and important. It’s not their job to make the industry happy, it’s their job to make the industry safe whether the industry likes that or not.
…All of which works fine until you get another anti-government ideologue in office, which is another way of saying that no governmental structure is proof against sabotage by its own leadership and ultimately, the responsibility for these particular failures of government rests with the electorate.
The concept is appealing in theory.
Actually it makes no sense at all in theory because it’s already been tested and disproven in practice.
1. Although the banks claimed to have everything figured out, they really all went catastrophically bankrupt.
2. Although everyone in business, politics, and the MSM claimed we have “capitalism”, and these were all self-reliant pioneer “entrepreneurs”, they were all already bailed out in practice, and the Bailout contines in full fury to this day. The Bailout is permanent for as long as it can be sustained.
So to believe anyone who says Bailout America, this kleptocratic regime, won’t augment the Bailout anytime it can, and especially in the next crash, is to exemplify the kind of insanity which keeps performing the same already-discredited act, expecting a different result.
3. There already exists a “resolution authority”, the PCA law. It was already disregarded in the moment it was designed for. Believing in any new “regulation” here is that same insanity again. We’ve already had proof of (anti-)principle.
4. The simple fact, which can be applied as a general template everywhere. If the system had the will to “resolve” these entrenched rackets, it would have the will to break them up completely. Lacking the will to do the latter, it will also never do the former.
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.”
I’d love to brand this into the consciousness of every American so that whenever they hear of a bankster bonus it’s the first thing they think of, and whenever they hear about or experience any bank abuse or fraud it’s the first thing they think of, and when the next crash comes it’s the first thing they think of.
Sorry to disagree with you, but I think Simon is correct.
Almost all large companies behave like the oil companies, the financial companies, tobacco companies, the military, the Catholic Church etc. for one simple reason: decisions and plans are made by people, not institutions. Almost all the people who make it to the top in large organizations have been homogenized and standardized by common experiences, outlook and personal incentives.
1. They worked their way through middle management by going along to get along.
2. They always followed orders and met the cultural expectations of their organization. Early in their careers they made a choice: they could make a difference or they could get promoted. (Those who make waves for senior management by trying to make a difference are considered disloyal, troublemakers, heretics, or whistleblowers)
3. They were tapped for greatness by a more senior person early in their careers. Usually because they reflected the beliefs of the kingmaker.
4. They have carefully accumulated “status” symbols like degrees, awards, medals, etc. They have avoided collecting demerits by taking risks.
5. They are culturally conditioned to administer their organizations much they are, not to deal with major change. Those who report to them and their boards of directors expect this behavior and changing makes control of their companies far less certain and far more difficult. (More importantly it risks their personal compensations)
6. They see the world from the tribal perspective of their organizations.
7. They see their position as a just reward for years of loyal service.
8. They’ve managed to manipulate their boards into immediately rewarding them for last year’s performance. (Over the last 50 years entire industries have been thus manipulated so boards now justify this compensation as “competitive”) Only upside rewards and sometimes even rewards when things go bad. No penalties. They are in the job for the money and prestige.
The exceptions to this herd of executives (Tony Hayward, Lloyd Blankfein, John Sculley, Steve Balmer, etc.) are those who self- select (Steve Jobs, Bill Gates, Henry Ford, etc.) and whose compensation is largely their ownership in the company with both the upside and downside risks. They share idealisms, drives and take risks make them unattractive to professional king makers (as demonstrated in the classic ouster of Jobs for Sculley by the professional board of Apple) Other exceptions, rare indeed, are those selected by more competent boards from successful leadership positions (or key members of executive teams) of highly successful smaller competitors; executives who’ve been tested in the marketplace, not coddled by the corporate culture and size. These executives bring in a different cultural perspective and start off by reaching outside the organization to bring in enough other key people to modify the corporate culture.
I could not agree more with almost all of your points and have made many of the same myself (see, e.g. http://www.theparetocommons.com/?p=95). But while these factors are easy to point out, the solutions are much harder. One is to break down ultra large companies, and I am all for that but I recognize the political obstacles faced by this solution. So what as a practical matter do we do about the problem now? I can assure you that the imposition of the requirement to write a plan for action in the case of an emergency, including dismantling the company, would, if properly supervised and enforced, force badly needed thinking within the company itself and be highly educational to both the company and its regulators (assuming they were serious regulators).
If you think this is all a worthless exercise then we might as well all give up. How do you think anything gets done in an organization? Spend some time in one and then let me know how you would do it. Basically, not all analysis and scenario planning is worthless. If that were the case the military would also be unable to function.
AIG caused more damage than it could pay for, didn’t it?
Years ago (in the days of Continential Illinois) the Treasury Dept. became concerned with the amount of ‘Daylight Overdrafts’ banks incurred in their daily operations with the Fed and inter-bank trading. After years of debate it was decided to limit these daylight overdrafts to a cap amount based on a simple formula the Fed used. All the banks wire systems were modified in order to track the overdrafts. All this was designed to limit systemic risk so that if a bank could not settle at the end of the day, an un-winding would not have to take place. All this is to say, there was a time not too long ago when the Fed and bank regulators actually regulated financial institutions.
Why do we think we should not return to that kind of oversight? We do we think that financial institutions and large corporations will conduct their business in a way that is consistent with the welfare our country, the environment, and the world?
I believe it is because we don’t think the government is any longer able to provide the kind of knowledgable oversight that is necessary to do the job. A sad day indeed.
Re: @ lawrence baxter___Whoa…you really boxed yourelf in on the bottom line.
Many of the biggest investments in the world are those of the petroleum industry (think of the Alaskan pipeline and the Gulf deep water platforms). While those petroleum executives are up on the stand, somebody should ask them whether they need banks over $100B. Those are the facts we could run with.
The Problem „incentives“ regarding having „systemic importance“ continiues in Switzerland.
According to the „Financial Stability Report, 2010“ (as of today) of the Swiss Nationalbank (SNB) Swiss banking sector assets amounted at the end of 2009 CHF 3’574 billion.
That means nearly 7 times Swiss annual GDP. Compared to the previous years it is a drop. But the size of the Swiss banking sector has still the biggest ratio among the G10 countries.
The SNB uses 3 criteria to asses the « systemic importance » of banks :
(2) interconnectedness and
But SNB admits that it is difficult to define suitable indicators, because the criterias often overlap.
Conclusion: Despite the reduction in their balance sheets the big swiss banks are still very large relative to Swiss GDP.
“Insurance, and Living Wills” seemingly date back to the British Empire three centuries ago. It was just a century or so ago that Walter Bagehot became editor-in-chief of the “Economist” of which his farther-in-law was James Wilson, the founder. Incidentally, Walter Bagehot wrote the fabulously famous book, “The English Constitution”- was instrumental in “America’s Central Banking Development”. Here’s where it gets dicey? Prior to the announcement Sept.19,2008 (The Big Heist?) Chairman Bernanke, and Secretary Paulson had intervined in credit markets during the current crisis based on the principles that economist Walter Bagehot had outlined for “Central Bank” behavior during crises more than a century ago. These include as follows: #1) Lend freely to illiquid but solvent financial institutions based on collateral that would be good under normal market conditions; #2) Charge a penalty interest rate to encourage these institutions to return to private funding sources as soon as possible; #3) Minimize market disruptions from the liquidation of insolvent financial institutions. Finally,…this is what Secretary Paulson has tried to minimize the moral hazard risk problems that may arise from federal interventions – at a minimum Paulson has insisted on: #1a) Removal of the BOD’s, and replacement of the CEO’s; #2a) Substantial dilution of existing common,and preferred shareholders through warrants (ie.,the right to buy newly issued shares at a fixed price in the future) so that most of any appreciation in the market value of these firms will go to the taxpayers. Ironically, the audacity, (gall is such a more appropriate word) to use a archaic century old thesis is utter malfeasance, coupled with gross negligence to ones fiduciary responsibility regarding our very countries frailities concerning the abandonment of tried-an-true timely empirical models! PS. The Economist then and now, was solely funded by the Rothschild family, and is currently wholly owned by Evelyn de Rothschild / Great Britain. Thanks Simon and James, excellent read :^)
We agree on breaking up behemoths. I too have written about that, and until that happens and they are prevented from regrowing thereafter through mergers and acquistions, we will face crisis after crisis.
Also, have spent time in large organizations up to department manager level. There are pools of excellence within many large organizations, but they seldom become sources of executive management. See my badly title post “How to get the most out of critics” ( http://www.dismountingourtiger.com/business-health/how-to-enthusiastically-get-the-most-out-of-critics/) for one example of a pool of excellence in Burroughs.
Have also self-selected as a CEO (for 16 years) and worked with CEO’s and other executives of all sized organizations.
The military too has pools of excellence and some excellent leaders who, on occasion get selected around the system to lead. Admiral Zumwalt, atomic submarines picked by Eisenhower, Gen. Grant finally picked by Lincoln based on successes out west after military promotion system had produced one incompetent general after another.
Simon, as always not only do you make strong and cogent points with which I agree entirely, but you also persist, day after day, in making those points. I follow this blog every day and most days stick in my .00002 cents worth. I am not a professional economist, but have studied it and believe that I understand the basics of macro. The problem is, after all is said and done, there is, presently and clearly, no real sufficient motivation on the part of our political leaders to demand or encourage change, or pass meaningful legislation to achieve that.
Oh, yes, there have been lots of over-the-top knee-jerk, grand-standing by the Congress and Administration. They have done this about health care, the wars, the financial crisis, and now the oil spill, and that just covers events in the last year or two. But, the bottom line, assured by Congress, and now the Supremes, is that the oligarchs have bought us, lock, stock and barrel. What you need to do is get in touch with Mr. Lessig at Harvard, who is advocating a Constitutional Convention. This is because the Citizens United case will make it absolutely impossible for the populace to wrest control of government from the oligarchs until there is a constitutional amendment to change the election process. No meaningful change is even possible in any area of American life to the betterment of the average citizen unless and until this is accomplished. Until that happens, there will be no chance for America to return to a real free market economy. The oligarchs have made a farce of the term free enterprise by creating a playing field that is so tilted in their favor that those who would attempt to gain traction against them are climbing an unscalable cliff in that attempt. End of story.
In a world where governments governed, regulators regulated, and business happened on a level playing field, we all would gain. But when .01% of the population controls 95% of the wealth and all of the power, that can’t happen. Many of us might well have been better off than we are now had we lived in the Eastern Bloc in the two decades of the ’70’s and ’80’s.
@ Lawrence Baxter
Are you the same Lawrence Baxter from Duke University who’s in Hong Kong currently?
Spot on! The difference between pretending to have a plan and having a plan, is that the latter is regularly rehearsed and changed based on the lessons learned from the rehearsals. Since the market is a game between humans that tries to win, rehearsals without the “bad guy” is close to pretending rehearsals. The challenge in a rehearsal of a “living will” or any other plan should come from a player that tries to win so much money from the winding down of the company as possible, and be the over all winner if he manage to create a true disaster, cashing in on all his CDSes or whatever. (.. that almost sounded like a story I read some time ago)
Re: @ Bayard Waterbury____Excellent read! I’d like to add alittle flavor if I might – an all too ominous, and telling quote from Andrew Carnegie: “An aristocracy of wealth is impossible…Wealth cannot remain permanently in any class if economic laws are allowed free play…Both social elites were forced to eccept rich newcomers”. end quote;…Carnegie’s manner then gravitates into a subtle yet implicit dialogue – referring, “unless they migrate into political theatre”? PS. Andrew Carnegie loved “Pomp”, and being known “Slave-Master/Owner” of the commoners too the Nth degree.
Edwin Lee, Zumwalt served on destroyers before rising to Chief of Naval Operations, you’re thinking Hyman Rickover, father of the nuclear Navy. He was a Chicago boy and in a nice touch, Mayor Daley named the city’s new Naval JROTC high school after him.
Question for Simon or James– if Russ Feingold’s possible Yea vote is nudging the conference committee towards the Volcker rule, is there a reason other pro-reform senators (say, Sherrod Brown, Bernie Sanders, Ted Kauffman, Maria Cantwell) aren’t bellying up to the bar to make their own demands?
Thanks for the correction, I once knew it was Hyman Rickover, but didn’t recall it accurately. Ah the aging process…. humbling.
The BP oil disaster is still in the making. Though it is comforting to believe that everything will be alright (like the recoveryless recovery).
Bayard, I agree the election process is ultimately the key to the problems with big finance, big oil, and corporations in general. A constitutional convention is not a bad idea, but that takes a very long time. Election reform is possible and can make a huge difference.
It all starts with how elections are financed. We should restrict, through federal election laws, contributions to candidates for federal office to residents of the election district. What this means is that only residents of a congressional district or state would be allowed to contribute to a candidate for that federal office. This federal election law would apply to Political Action Committees as well. Corporations would only be allowed to broadcast political messages in the state they are incorporated in. This would not only reduce the influence of corporations on elections but would also reduce the size and duration of election campaigns. Only when most, if not all, corporate money is eliminated from the election process will our congress and government begin to act as servants of the people instead of servants of big business.
This law may require a constitutional amendment. Eliminating political action committees altogether would be the best. The only contributions to a political campaign should be from citizens of the district.
BLAME THE SPILL ON THE BABY BOOMERS:
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