The price of resolution November 8, 2013 at 10:10 am

Simon Johnson has a very good point. First he points out that most experts agree that

bankruptcy cannot work for large, complex financial institutions in the United States, at least not using the current bankruptcy code.

It can and does work for non-financials, and the FDIC work out process for small banks works well without protecting shareholders or management. Big banks, though, will be resolved and will almost certainly require liquidity assistance from the FED during this process. Even if the process is similar for large and small, the very fact that bankruptcy isn’t possible for the large gives them an advantage, Johnson claims:

Because big banks cannot go bankrupt, they have an unfair advantage against everyone else in the financial sector. The counterparty risk of trading with them is lower, and thus they are regarded as a better credit risk than would otherwise be the case. This allows them to place bigger bets, which in turn creates more risk for the macroeconomy.

The intent behind Title I of Dodd-Frank is clear. If large complex financial institutions cannot go bankrupt, then they must be forced to change the scale and nature of their operations until each and every company is small enough and simple enough to fail without disrupting the world economy.

We have agreed with Johnson’s conclusion in the past here, and pointed out that the current state of affairs represents a real advantage to large firms that has not been endogenized. Indeed, as Bill Dudley points out:

ongoing research by Federal Reserve Bank of New York staff shows that the funding advantage of large versus small banks is higher than the funding advantage for large versus small non-bank financial firms and non-financial firms when other factors are held constant… [Moreover] the major rating agencies add an uplift to their credit ratings for the largest banks due to the prospect of government support. While it is possible that the rating agencies are wrong in their assessment, what matters is perception. If investors share this view or simply follow the ratings, then this should create a too big to fail funding advantage.

Clearly making big banks resolvable is important. But just as important, for me, is endogenizing their cost advantage. Increasingly I prefer an ex ante tax to level the playing field and provide an economic incentive to split up. There are so many advantages to being big that a counterveiling force would be welcome.

2 Responses to “The price of resolution”

  1. But what about the temporary stay that will be imposed on derivatives contracts of a big bank being bailed in? Is that not a cost that the big bank resolution imposes on counterparties and so shld be internalised? Or are you saying this is less cost than that imposed on counterparties of smaller banks that do go insolvent? Also what abt the additional LAC the big guys will have to carry around? Surely that’s like a tax?

  2. QM – that’s an interesting question. I hadn’t thought about the stay as a tax, but clearly it in some sense is.

    Musing a bit more about this makes me wonder whether in addition to having a minimum amount of bail-in’able debt, SIFIs should have a minimum about of deferrable & extensible debt.

    What I am saying is that a non-systemic bank with ‘the same’ PD as a systemic one funds more expensively because there are tails of the loss distribution for the former that are less likely for the latter due to recovery/resolution regimes. The small guy therefore funds more expensively because the EL is higher.