If there is one lesson to be learnt from the subprime financial crisis, it is that large financial institutions (LFIs) are too big to fail. The backlash following the demise of Lehman Brothers and the effort to save major financial institutions at all costs have established that governments, even in the developed countries, do not have the political will to let a large financial institution fail. Whether the too-big-to-fail doctrine is driven by the economic reason that the cost of such a failure is too high or it is a manifestation of the political reality that the pressure to save such institutions is too strong, the conclusion is the same: we need to rethink how we regulate these institutions.
Traditionally, bank capital regulation has been thought of as a corollary to the introduction of deposit insurance. The existence of deposit insurance makes debt a cheap source of financing for banks. Depositors and other creditors will lend at low interest rates because they know that their debts are secure: they will be repaid by the bank if things go well and by the government if things go badly. Capital requirements, then, are a necessary evil to prevent banks from abusing the ability to borrow cheaply, over-leverage and dump large losses onto taxpayers. However, the traditional capital requirements have not applied to investment banks, in spite of their size, because they had no insured deposits. The events of 2008 have shown the futility of this distinction. In spite of not having deposits, investment banks experienced a loss of confidence on the part of their short-term creditors, and because of the alleged systemic implications of this event, they were rescued by the US Federal government.
Shielding a LFI from bankruptcy has a cost. In a market economy, bankruptcy accomplishes several important goals. It allows an efficient choice to be made between reorganisation and liquidation; it penalises incumbent management and shareholders; and it resolves conflicting claims. But for LFIs, bankruptcy may be dangerous. When a LFI goes bankrupt, its contracts are put in jeopardy and other LFIs can suffer because they suddenly find their positions unhedged. Reconstituting their hedges overnight can be prohibitively expensive, pushing other LFIs into bankruptcy and leading to systemic failure.
Therefore, if we want to maintain a system of private financial institutions that are too big to fail, we need a mechanism that performs the same functions as modern bankruptcy, but without the drawbacks. A recent paper by Prof Luigi Zingales at the University of Chicago and Prof Oliver Hart at Harvard University suggests such a mechanism. Their mechanism mimics the way margin calls function. LFIs will post enough equity to ensure that the debt (all debt and not just deposits) is certainly repaid in full. When fluctuations in the value of the underlying assets puts the LFI?s debt at risk, LFI equityholders are faced with a margin call. They must either inject new capital or lose their equity in the bank.However, the trigger mechanism for the margin call is different since the value of the LFI?s assets is not easily determinable. The LFI?s assets consist of commercial loans and home loans that are not standardised and not frequently traded.
Thus, it is not easy to determine when the margin is too thin to protect the existing debt. If a margin call approach is to be followed, an easily observable trigger needs to be found.
To solve this problem, the authors suggest using information from the credit default swap (CDS) market. A CDS on a LFI is an insurance claim that pays off if the LFI fails and creditors are not paid in full. Therefore, its price reflects the probability that the LFI?s debt will not be repaid in full. When the CDS price rises above a critical threshold, the regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If the LFI does not put in additional equity within a predetermined period of time, the regulator intervenes and finds that the LFI?s debt is at risk, it then forces the LFI into reorganisation. The regulator replaces the CEO with a trustee, who wipes out the initial equity and debt, but not the derivative contracts. Then the trustee puts in place a new capital structure that avoids future bankruptcy; sells the LFI expeditiously (possibly through a public offering); and distributes the proceeds to former creditors. In this process, the trustee ensures that creditors are partially repaid and that shareholders receive nothing, which ensures that the shareholders get hurt for their misdemeanours. Anything left over goes to the government.This regulatory takeover is similar to a milder form of bankruptcy, and it achieves the goals of bankruptcy, i.e, disciplining the investors and the management, without imposing any of the costs stemming from systemic risk.
The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at ISB, Hyderabad. These are his personal views