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

Bank Resolution Concepts, Tradeoffs, and Changes in Practices1

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

Bank Resolution Concepts, Tradeoffs, and Changes in Practices1

Article excerpt

1. INTRODUCTION

During the recent crisis, some of the world's largest and most prominent financial institutions failed or nearly failed, requiring intervention and assistance from regulators. Measures included extended access to lender of last resort facilities, debt guarantees, and injection of capital to mitigate the distress. 2

Figure 1 shows some of the largest financial institutions that failed and/or received government support during the recent crisis. As one can see, these institutions were large and systemically important. For example, for a brief period in 2009 Royal Bank of Scotland (RBS) was the largest company by both assets and liabilities in the world. Table 1 summarizes the interventions and resolutions of major financial institutions that experienced difficulties during the recent crisis. The figure and the table indicate the extraordinary levels of distress throughout the system and the unprecedented range of actions taken by resolution authorities, as many countries lacked an efficient framework for resolving large and systemically important financial institutions.

In the United States, prior to the passage of the Dodd Frank Act, insolvent nondeposit-taking institutions were dealt with under the Bankruptcy Code, as opposed to the special resolution regime administered by the Federal Deposit Insurance Corporation (FDIC). Figure 2 shows the largest corporate bankruptcies in U.S. history; Lehman Brothers was by far the greatest. In the absence of an orderly resolution regime, the failure of Lehman led to unprecedented disruptions in financial systems globally. While many counterparties to Lehman suffered direct losses, others experienced distress due to information contagion and fire-sale externalities from a sell-offin assets.

One of the most significant effects was on the money market mutual fund industry, where the Reserve Primary Fund, the oldest money market fund, "broke the buck" because of its exposure to Lehman Brothers debt securities and had to be liquidated, marking only the second such episode in history. This event led to a run on the money market mutual fund industry, which adversely affected the shadow banking industry.3 Regulators attempted to contain the disruptions in financial markets with extraordinary interventions including capital injections, debt guarantee programs and many lending facilities.

Financial intermediaries and banks perform important roles for the efficient functioning of the economy, such as channeling funds from savers to investors and providing payment services, and their liquid liabilities can act as money. As a result, failure of these institutions can pose significant disruptions, and corporate bankruptcy may not be the appropriate resolution regime.4 Hence, authorities use various methods to resolve failed banks ranging from full or partial private sector resolution methods-such as the sale of the bank to a healthy bank via Merger and Acquisition (M&A) or the transfer or sales of all or parts of the assets and liabilities to another bank via Purchase and Assumption (P&A)-to government intervention using public funds to recapitalize banks.

This paper provides a discussion of the costs associated with different resolution methods. Furthermore, we provide a simple framework to analyze the optimality of resolution methods. We show that private resolution methods, such as M&A and P&A, are preferred options since they minimize the costs associated with bank failures and their resolution.

The availability of resolution options certainly depend on the characteristics of the failed bank. For example, when the losses in the failed bank are large, there may not be a ready buyer for the bank without assistance. Furthermore, if the failed bank is large and complex or if failure occurs during a systemic crisis that causes many banks to experience distress, it may not be feasible to find a healthy bank to acquire the failed bank, and the regulators may need to employ alternative resolution methods such as liquidation or recapitalization. …

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