Academic journal article Federal Reserve Bank of New York Economic Policy Review

What Makes Large Bank Failures So Messy and What Should Be Done about It?

Academic journal article Federal Reserve Bank of New York Economic Policy Review

What Makes Large Bank Failures So Messy and What Should Be Done about It?

Article excerpt

* The failures of large banks are not only costly--they destroy asset value and consume legal resources--but also destabilizing, in that they spill over to other financial institutions and cause more widespread instability.

* The messiness of these failures can be traced in part to large banks' reliance on uninsured financial liabilities (UFLs). UFLs include uninsured foreign and domestic deposits, repurchase agreements (repos), commercial paper, and trading derivative liabilities.

* To ease the problem of large banks' disorderly failures, regulators might require the banks to issue a certain amount of long-term "bail-in-able" debt, or "at-risk" debt that converts to equity in resolution.

* The stabilizing effects of an at-risk debt requirement cannot be achieved by simply requiring more equity; bail-in-able debt and equity are not perfect substitutes in providing financial stability if the resolution authority is slow to close the bank.

1. INTRODUCTION

This article uses "messy" repeatedly, so we should be clear at the outset what we mean by this term. Simply put, we mean that the failures of large banks are costly--in terms of destruction of asset value arising from fire sales--and also destabilizing--meaning their failure can threaten the operation of financial markets generally. We maintain that messy failures, so defined, are unique to large, complex, and interconnected banking firms. A small bank failure is costly, in terms of lost local output (Ashcraft 2005), but it does not threaten the smooth functioning of the financial system at large. Thus, small bank failures are costly, but not destabilizing. The failure of a large nonfinancial firm can also be costly, but it is not usually considered destabilizing; when the bankruptcy of General Motors Company was considered, most of the discussion was about lost jobs, not the stability of the automobile sector.

We contend that the reliance of large banks on uninsured financial liabilities is a key reason why their failures are so messy. We define uninsured financial liabilities (UFL) according to Sommer (2014) as liabilities that are issued specifically by financial firms, that is, uninsured foreign and domestic deposits, repurchase agreements (repos), commercial paper, and trading derivative liabilities. (1) These liabilities are special for two reasons. First, unlike a regular debt liability of a nonfinancial firm, uninsured financial liabilities confer money-like or liquidity services that may be impaired or destroyed in bankruptcy. This is one reason why the failure of financial firms is especially costly or messy. Another reason is that uninsured financial liabilities are runnable. Runs on the large firms relying heavily on UFL (or financial liabilities that are not fully collateralized) trigger fire sales that inflict losses not just on the firm in question, but also on other firms with similar portfolios of assets. That is what we mean by destabilizing--it is the threat of systemic consequences associated with the failure of a very large bank.

Our claim that the liabilities of financial firms are the defining feature that makes failures messy is not incompatible with the view that illiquid asset holdings or organizational/global complexity contributes to messy failures. While illiquid assets and organizational complexity are undoubtedly important, we suggest that large banks' liability structure is the defining feature that leads to messy failures. Simplifying a bit, uninsured financial liabilities are those liabilities that are runnable. When a financial firm experiences a run or fears a run in some part of its organization, it can trigger a fire sale of its assets as well as runs by holders of runnable liabilities in other parts of the firm or in other firms. So, in our view, the risk of a run is the element that catalyzes the fire sales and other rapid and destabilizing effects of a failure. The run creates a messy situation because as the holders of runnable liabilities run, they steal time from all other decisionmakers to respond in an orderly manner. …

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