Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The Pharoah’s funeral plans

Post crisis, there has been a lot of interest in ensuring that large banks prepare a living will or funeral plan describing how they will be resolved if they fail. Though this does look like a good idea, I think there is a catch which is best illustrated with an example.

Some of the most successful funeral plans in history were of the Egyptian Pharoahs who began their reigns with the construction of the pyramids in which they were to be entombed. If anything, this would have increased the cost of the funeral. It is very likely that left to their successors, the pyramids would have been less grandiose. Moreover, to a finance person it is obvious that the present value of the cost increased because the pyramids were built earlier than required.

Much the same thing may be true of the banks as well. Funeral plans may make regulators complacent about excessively large and complex banks; as a results, the costs would be higher when they do fail. Banks may also incur a lot of wasteful expenditure to prepare and defend funeral plans that may ultimately prove useless. The existence of these plans may lead to delays in taking prompt and corrective action for vulnerable banks. Why shut down a bank now when you believe (perhaps wrongly) that it can be shut down later without great difficulty? In short, the plans may allow mere words to substitute for real action.

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