With the collapse of Lehman Brothers in 2008, the world got a taste of the domino effect that can be created when a systemically important financial institution (SIFI) fails.
In the backlash that has occurred since, risk management has become the primary focus of the Financial Stability Board (FSB), and with good reason.
In an effort to prevent future economic crises resulting from SIFI failures, the FSB has developed a proposal for living wills, or effective resolution regimes, for financial institutions. The FSB criteria for an effective resolution regime are outlined in Key Attributes of Effective Resolution Regimes for Financial Institutions .
The objectives of living wills are: Ensuring continuity of financial services. Protecting client assets. Allocating losses to shareholders while respecting the hierarchy of claims. Not relying on public solvency support. Avoiding unnecessary destruction of value. Providing speed, transparency and predictability for orderly resolution. Legally mandating cooperation, coordination and information exchange with relevant resolution authorities. Ensuring orderly market exits by non-viable firms and enhancing market discipline and offering incentives for market-based solutions.
In the event that risk management measures fail and a financial institution becomes no longer viable, the FSB proposal recommends that the living will should have provisions for two important activities: stabilization and liquidation. Stabilization is necessary for ensuring the continuity of vital financial services and may be achieved through sale of the firm to a third party or creditor-financed re-capitalization.
After or concurrent with stabilization measures, the liquidation phase must protect insured depositors, insurance policy holders and other retail customers, while winding down business operations in an orderly manner. SIFIs are by definition critical to the success or failure of an economy. It is for this reason that measures beyond standard risk management practices should be required.
A living will allows authorities to resolve a failed financial institution or large company while minimizing risk to the taxpayer and ensuring continuity of critical financial services. However, implementing living wills as part of a larger risk management strategy should not be limited to just the 29 SIFIs that have been identified by the FSB.
All large companies and financial institutions should have a living will in place in the event that existing risk management systems fail.