Monday, December 10, 2012

When global banks fail, they should be resolved globally

In their Financial Times column, the Bank of England's Paul Tucker and the FDIC's Martin Gruenberg put forth a proposal for how to resolve the Too Big To Fail if they fail:  resolve them globally.

I haven't spent a lot of time writing about how to resolve the TBTF for two reasons.

First, modern banks are designed so that the only time they have to be resolved is when they are no longer capable of generating earnings.

This resolution criteria reflect the simple fact that due to the combination of deposit insurance and access to central bank funding banks can continue to operate and support the real economy even when they have low or negative book capital levels.

Second, requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details would greatly reduce the possibility that a TBTF would need to be resolved.

Simply put, ultra transparency would subject the TBTF to market discipline for the first time in decades by linking a TBTF's cost of funds to the risk it is taking.  This restrains the TBTF's risk taking as more risk leads to a higher cost of funds.

Ultra transparency also helps in the resolution process.

First, market participants adjust the amount of their exposure to reflect both the risk of each bank and what they can afford to lose given this risk.  As a result, regulators don't have to worry about contagion from shutting down a TBTF.

Second, with ultra transparency, market participants can see when a TBTF is going to be taken over because it can no longer generate earnings.  Hence, the regulators stepping in to resolve a TBTF is not random and there is no 'surprise' that could disrupt the market.

Finally, your humble blogger thinks that Mr. Tucker and Mr. Gruenberg are headed in the right direction in focusing on resolving global banks on a global basis.

This is one of the reason why I have argued that ultra transparency must be applied on a global basis to all of a bank's exposures.

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