On July 3, the Federal Deposit Insurance Corp. and the Federal Reserve made public portions of the “living wills” developed recently by major U.S. financial institutions. The documents are the first suggestions from those organizations of what they believe should happen when insolvency looms.

The living wills were prepared in compliance with the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and are a major step forward in terms of revealing how global megabanks are structured. Yet they are shockingly incomplete and flawed in one crucial aspect: They neglect to explain how cross-border assets and liabilities would be handled in different legal jurisdictions.

The plans should be rejected by officials and sent back to the banks to be revised. As these proposals now stand, they are a blueprint for further financial disaster, and additional taxpayer-backed bailouts. (Note: the published parts of these wills haven’t been edited or reviewed by the FDIC or the Fed.)

To the more cynically minded, ignoring cross-border issues is akin to planting a poison pill in the heart of these living wills. When the time comes to wind down a failing megabank, the complexities and potentially dangerous domino effects surrounding the failure of a cross-border institution are likely to increase pressure for a bailout that will protect creditors, and perhaps shareholders and executives, too.

Flawed Incentives

This is exactly the wrong incentive structure for these banks; it will encourage reckless risk-taking and compensation programs that give management the upside in good times and, when things go badly, the downside losses are pushed onto society.

The legislative and regulatory intent behind living wills is straightforward and sensible. The biggest financial institutions operating in the U.S. are being pressed to help officials understand how best to handle a potential failure without bringing down the financial system.

After the 2008 demise of Lehman Brothers Holdings Inc. the thinking is that saying “just go bankrupt” to a large international bank could cause a great deal of damage across financial markets and around the world. Bankruptcy procedures aren’t well suited to some parts of financial services where there is a great loss of value when funding is no longer available. Creditors are likely to recover no more than 25 cents on the dollar from Lehman, when all is said and done.

But the biggest costs were incurred when the fall of Lehman created fear and disrupted markets more broadly, leading directly to the deepest recession since the 1930s.

If the bankruptcy of a large institution would result in broad financial instability, the FDIC is charged with figuring out how to implement Title II of Dodd-Frank to handle the company’s failure. This new authority is an alternative resolution mechanism that would allow officials to liquidate large financial institutions in an orderly manner. The FDIC’s responsibility turns out to be an extremely complicated and difficult task, precisely because the largest modern banks are so big, and are structured in Byzantine fashion. All the more reason these living wills ultimately need to be credible. (I serve on the FDIC’s Systemic Resolution Advisory Committee, but that panel’s role is only to provide feedback in a public forum.)

The plans available so far are from five of the six largest U.S. financial institutions: JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley. Wells Fargo & Co. hasn’t submitted a will, which is interesting given that the bank is spending a fortune on lobbying and is definitely in the “too-big-to-fail” category (as the country’s fourth-largest institution by assets).

Holding Companies

Each of the U.S. filers has at least two living wills, one for the holding company and one for the bank; Bank of America has a third for its card services. Some of the largest European banks operating in the U.S. are also represented: Barclays Plc, Deutsche Bank AG, Credit Suisse Group AG and UBS AG; other international players have yet to show their hand (I’m very interested in what the French have to say).

There is useful information here -- particularly in the way that some banks emphasize that parts of operations could be valuable when broken off and sold (JPMorgan makes this point). Executives of these megabanks sometimes suggest that their businesses could only exist in the behemoth size, though that isn’t the implication of these living wills.

The important consideration, however, is how assets and liabilities would be handled when there are cross-border operations and markets, or when officials start to fear that a collapse may be imminent. What assets can be moved and under what conditions? What can be seized by responsible legal authorities in various countries?

And how will client money be protected in this situation? As seen in the MF Global Holdings Ltd. case, the treatment of customers and other claimants in London and in New York can be very different.

These international banks like to book their business in various jurisdictions, driven by tax or accounting convenience or regulatory requirements (in the sense of getting around such requirements). The result is a tangle of obligations within the “banks,” that is across the various legal entities that are owned by the holding company, some of which are banks and some of which aren’t.

Ideally, these banks should be organized as separate legal entities, each with its own capital -- and each able to fail “on its own,” without bringing down the rest of the business. There should be no cross-guarantees or other hidden ways of sharing assets and liabilities.

To the extent that any financial institution operates across borders, it should have to justify the social benefit, and explain precisely and in a public manner how this cross-border activity is structured to avoid a systemic risk.

The living-will exercise should be an opportunity for officials to force the global megabanks to simplify along national lines and to build up their equity capital. Unfortunately, while some officials are inclined to push in that direction, other powerful figures -- including at the U.S. Treasury Department and within the Federal Reserve System -- are surprisingly complacent regarding the status quo.

Ultimately, all these living wills are likely to achieve is to illustrate further that that our largest financial institutions still constitute a time bomb, ticking quietly near the center of the global economy.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

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To contact the writer of this article: Simon Johnson at sjohnson@mit.edu.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.