Meir Chaimowitz/NurPhoto via AP
Only a handful of U.S. banks are so big that they have to tell the government how to manage them if they blow themselves up. So we should be aware that four of those banks submitted instructions for unwinding themselves that did not fully comply with this governmental directive. Four might not sound like a lot, but it was four out of eight.
Citigroup, JPMorgan Chase, Bank of America, and Goldman Sachs presented so-called “living wills” that were inadequate, regulators announced last Friday. But some of the regulators didn’t fully agree with that. The living will process is a shared responsibility of both the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve. The FDIC was prepared to announce that Citigroup’s violation, which was more severe than that of the other three banks, constituted a “deficiency”—shorthand for saying that the plans wouldn’t actually unwind Citi in an orderly fashion if it got into trouble.
But the Fed disagreed, so Citi’s grade was softened to a “shortcoming.” Citigroup need only develop a remediation plan by September 1; the remedies that would involve serious changes to its business were dropped.
In other words, Jerome Powell and the Fed weakened the consequences for Citigroup, relative to Joe Biden’s regulatory officials at the FDIC, who saw the living will plan as unworkable. Keep in mind that one of the remedies for a deficient living will is literally to break up the business lines of the offending bank—for instance, forcing it to sell off its derivatives business, or downsize its assets, or completely separate the commercial from the investment bank. The FDIC assessment is that we might need to consider that, and the Fed essentially shut that down.
This is not the only example of the Fed watering down regulatory oversight of the big banks. Just yesterday, Bloomberg reported that the central bank has shown other regulators a significantly weaker version of a new capital requirements plan, under which big banks would be required to carry far less funding to absorb losses in case of trouble. This follows an intense bank lobbying campaign that appears to have found a receptive target at the Fed.
In a theoretical vacuum, these are pretty bad developments, though hopefully we won’t get to the point where Citi implodes for a second time this century. Obviously, regulators have other tools to stave that off; the living will is supposed to be a fail-safe to prevent more cascading outcomes in a crisis scenario. But what if that crisis scenario is not as far off as we thought?
To back up, here’s what was wrong with Citigroup’s living will. Essentially, the biggest banks are asked to simulate a failure in their operations, and explain how the bank could be resolved with minimal disruption to the rest of the financial system. Then the regulators assess whether those resolution plans will actually work.
The FDIC’s designation of Citi’s living will as deficient is probably closer to the truth than the Fed’s.
As Rohit Chopra, the director of the Consumer Financial Protection Bureau and by virtue of that position a member of the FDIC board, explained, “In reviewing the latest living will submission, we tested the firm’s capabilities and asked it to quickly unwind its derivatives portfolio. It could not do so. As expected, the firm produced materially inaccurate data during this test. The reliability and fragmentation of its internal systems could preclude the firm from credibly executing its living will.”
Chopra says “as expected” because Citigroup has been sanctioned in the recent past for being unable to safely manage risk. And just two years ago, the FDIC and the Fed dinged Citi for not being able to articulate its capital and liquidity needs during the process, which would make it unable to even understand its solvency position and what lines of business would be unable to continue.
The current plan, which was submitted in 2023, was deficient, according to the FDIC, on the derivatives portfolio, the large collection of “bets on top of bets” that banks often hold. “The firm lacks the capability to incorporate updated stress scenarios and assumptions,” regulators told Citigroup, and this would again make their determination of capital and liquidity needs inaccurate. In short, if you don’t know the value of your derivatives holdings under catastrophe scenarios, you have no window into knowing the relative health of your business.
These weaknesses were also present in the 2021 plan, which makes things even worse. It means that the FDIC’s designation of Citi’s living will as deficient is probably closer to the truth than the Fed’s, as the problem is ongoing.
Again, if the outlook for the financial system is relatively stable, this is a theoretical problem. But crises have a way of sneaking up on everyone, which is why this living will test is so important. And indeed, there is a horizon-level event that could bring major stress to the system.
Observers have been waiting uneasily for a collapse in the $2.5 trillion commercial real estate market. The rise of working from home since the pandemic has hollowed out central business districts across America, and as companies need less office space, they may give up leases, leaving mortgage holders scrambling.
So far, the strategy has been to “extend and pretend”—to roll over the debt and hope that everyone can climb out of the hole. But a few weeks ago, an almost totally unnoticed milestone was hit. A $308 million commercial real estate bond tied to an office building in Manhattan (1740 Broadway) took significant losses, such that even the AAA-rated top tranche only paid out at 74 percent. Investors in the lower tranches were completely wiped out.
This is the kind of scenario you saw during the financial crisis, when lower-level investors lost their shirts and even the “safe” investors took haircuts. With interest rates rising, vacancies at record highs, and significant sums of debt maturing, there are losses in the system that are threatening to cascade.
That might affect the nation’s largest banks, which have at least some exposure to commercial real estate debt and commercial mortgage-backed securities (CMBS). The New York Times reported on Monday that several banks have been selling stakes in commercial real estate portfolios, trying to get out before a broader collapse. That includes a sale by Goldman Sachs, one of the companies tagged with shortcomings in its living will submission. And last year, there was a default on a $1.7 billion commercial real estate loan partially arranged by Citigroup.
These sales are an acknowledgment that losses are coming due. Delinquencies may be rather low at this point, but the indications are that they will grow, at least according to the financiers who would be in a position to know.
That puts a different spin on this whole living will issue. I’m not saying there is an imminent commercial real estate crash, but it’s more of a risk now than it was when banks submitted these resolution plans. Regional banks are more exposed to this type of debt—First Republic and Signature Bank, both of which collapsed last year, had large CRE holdings—but the tight coupling of the financial system means that nobody is truly immune.
Therefore, actually getting the living wills right is that much more critical. And the Federal Reserve giving Citigroup a break on its problems looks that much more indefensible.
