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Preparing for failure is the answer to too-big-to-fail

Too big to fail | Preparing for failure is the answer to too-big-to-fail Anthony Harrington

Amongst all the heated rhetoric from politicians and the barbs hurled by commentators of all stripes, the global financial services industry, operating through the Institute of International Finance (IIF), has issued its own view of the solution to the too-big-to-fail dilemma. The optimum solution, it says in a report issued in May this year, is one where no taxpayer bailout money is ever necessary because the industry in general and every bank and financial services sector player has the necessary orderly wind up procedures in place across its entire portfolio of operations.

In particular, the paper addresses two key issues, the necessity for shareholders and unsecured creditors to face up to the fact that they will be the losers if banks fail, and the case of banks that operate across multiple borders. The first is a relatively straightforward proposition and it calls, in essence, for much greater shareholder activism, which is a topic we have addressed before in these blogs. If shareholders know that they are not going to be bailed out, then they will take much more interest in reigning in exuberant behaviour by the banks. The second proposition, addressing the global versus local issue, is a more complicated idea that needs machinery that is simply not in existence at present.

For this reason, the IFF Report calls for the G20 to set up a working committee to define an international framework for resolving failed cross-border entities. The report is specific and detailed in its recommendations:

Convergence of national resolution regimes is an essential requirement for ensuring that global firms are able to fail and exit the market in an orderly way. All major jurisdictions should have in place special resolution regimes…

A global framework needs to address, among other things, the complexities arising from the distribution of global firms’ assets and liabilities at the time of failure. To ensure equitable cross-border outcomes there should be further exploration of issues relating to integrated groups and the effects of legal entity–based resolution and insolvency regimes. Innovative approaches should be explored for achieving equitable cross-border outcomes within a group consistent with appropriate creditor expectations. Among the mechanisms to be considered should be asset allocation techniques designed to unwind certain intra-group transactions.

This is all excellent stuff and something that the various national and supra-national regulatory authorities will have to roll up their sleeves and get down to. Solving bank failures on the basis of ring fencing each “problem” on a national basis would simply create intractable muddles and lengthy disputes. Part of the silver lining in the failure of Lehman Brothers was undoubtedly the (more or less) smooth way in which the vast web of collateralised transactions was unwound by central counter parties, with the collateral of the defaulting party being turned into cash to reimburse losses at a very good pace.

The only hiccup in this process was when PwC, the Lehman liquidator, decided not to release some client funds and collateral until ownership issues were fully sorted out. That little incident resulted in a surge of enthusiasm for brokers offering segregated funds where ownership is beyond question, but that is a solution which the market itself has come up with and that does not appear to require regulatory intervention.

The intractable muddles that developed in the financial system following the crash had to do with the spread of “tainted assets”. In particular, the trouble that came from bundles of securitised residential mortgage backed assets that were sliced, diced and resold all over the shop till no one was clear who held what or was exposed to what. The debt overhang on credit default swaps was another source of poison. It is not entirely clear from the IIF’s report what the mechanism would be to prevent such a contagion happening again. But at least the IFF is envisaging a forum where such an issue could be pondered. One to watch.

Further reading on regulation and the crash

Tags: banking , credit default swaps , financial crisis , G20 , regulation , residential mortgage backed securities , Too big to fail
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