Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Letting large banks fail

I wrote a column
in the Financial Express today about the reform
legislation winding its way through the US Congress. I argue that the
regulatory goal of making large banks failure proof will not be
realized and that it is better to have a policy of letting even large
banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the
global financial crisis with three simple words: “No more
Lehmans.” In the short run, this statement could mean that there
would be no more bankruptcies like Lehman – any large financial
entity on the verge of failure would be simply bailed out. AIG was the
first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can
only mean that there would be no more failures like Lehman. Either
financial entities should be unimportant enough to be safely left to
the bankruptcy courts when they fail, or they should be robust enough
to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a
comprehensive 1,279-page Financial Reform Bill, but the Bill could
change significantly before it is passed by the Senate and becomes
law. How effective would this law be in eliminating Lehman-like

First, the new US provisions (as well as the recent Basel proposals at
the global level) impose higher capital requirements on financial
institutions. While higher capital would reduce the chances of
failure, it would not make failures so unlikely that governments can
safely promise to bail out any large bank that slips through the
cracks. Other elements of the new legislation are, therefore, designed
to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution
mechanism for failed banks to systemically important non-banks and
bank holding companies. Under the old law, Lehman could not have been
resolved in this manner and while the banking part of Citigroup could
have been resolved, the holding company itself (which owned many of
the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to
contemplate the failure of a large entity because the messy bankruptcy
is replaced by a more orderly resolution process. There is also a
provision for a bailout fund (Systemic Dissolution Fund) to facilitate
the resolution process, but this fund is to be financed by
contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out
shareholders of a large entity, it actually formalises the bail-out of
their creditors through the systemic dissolution fund. It would,
therefore, have the perverse effect of encouraging banks to become
even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC
(over-the-counter) derivatives market. Lehman was not spectacularly
large in terms of assets and liabilities. The systemic importance of
Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large
counterparty for subprime-related credit default swaps. They were not
too large to fail, but were described as too interconnected to
fail. Reform of OTC derivatives is intended to prevent this kind of a
situation from arising.

The straightforward solution to the OTC derivative problem is to move
these derivatives to the exchanges where a central counterparty (the
clearing house) collects margins from all participants and assumes
responsibility for all trades. Lehman did have a portfolio of 66,000
contracts totalling $9 trillion of interest rate swaps cleared by
LCH.Clearnet in London. LCH not only resolved the Lehman default
without any loss, but also returned a large part of the margins that
it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman
had sold $100 billion of a certain OTC swap to some parties and bought
$90 billion of the same OTC swap from others. Its failure would force
all its counterparties to terminate their $190 billion of Lehman deals
and establish new contracts with other counterparties. When all these
trades are done through an exchange, the clearing house would have to
liquidate only the net position of $10 billion, and this is easier
because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives,
but the proposals are riddled with loopholes that threaten to make
them ineffective. First, it does not mandate exchange trading; it only
mandates clearing and that too if a clearing house accepts the
concerned derivative for clearing. Second, many OTC derivatives lack
price transparency and are therefore illiquid. Without a push towards
transparency, many derivatives will simply be unacceptable for
clearing. Third, minor changes in terms may make a derivative
non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with
loopholes in this legislation will not make Lehmans sufficiently
unlikely in future. I would suggest that ‘No more Lehmans’
is not the correct policy after all. True capitalism is about letting
insolvent banks fail, however painful that might be.

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