Opinion

Felix Salmon

Resolving banks by guaranteeing short-term debt

By Felix Salmon
September 30, 2009

Robert Pozen has an interesting idea:

In my view, the adverse repercussions of Lehman’ failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman’s commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.

James Kwak tries to flesh it out:

Once the government has determined which liabilities and exposures will have systemic ripple effects (he says short-term CP and outstanding trades), it could just announce a guarantee on those liabilities and exposures and let everything else go into bankruptcy. Now maybe they didn’t have time to make such a determination the weekend before Lehman failed (although arguably they had since March to figure it out), but by the time Citi and BAC and the last AIG bailout rolled around arguably they did. I’m not enough of a markets person to be sure this would work, but it seems like a viable proposal.

One has to be careful when using the term “bankruptcy” with respect to banks, because I think what we really want here is a massive debt-for-equity swap which keeps the bank viable in some form, rather than outright liquidation (which is what banks have to do if they file for bankruptcy). Given the fact that recovery rates for unsecured bank creditors in liquidation are very close to zero, few creditors would be likely to object to such a thing. Is such a thing possible under the government’s existing resolution authority? I’m unclear on that, but I’m definitely interested in the details of Pozen’s proposal.

One big problem here is that such a plan can’t really be institutionalized ex ante: the last thing we need is an incentive for too-big-to-fail banks to borrow short rather than long, because there’s a semi-explicit government guarantee on all of their funding less than 60 days. Or maybe the Fed could force all banks to have no more than x% of their unsecured debt in the form of commercial paper.

Comments
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“Given the fact that recovery rates for unsecured bank creditors in liquidation are very close to zero, few creditors would be likely to object to such a thing.”
This seems very naive to me. You’d instantly have a flood of lawsuits from longer term creditors (not to mention employees). And I’d be very surprised if it were legal under existing law.

Posted by Ginger Yellow | Report as abusive
 

@Ginger Yellow: On what grounds would the longer-term creditors (or employees) sue? I’m happy to believe that they might want to, but I don’t see how they could …

@Felix Salmon: With the ex ante commitment problem: Why not have the government say that they’ll guarantee short-term debt to a particular multiple (possibly less than one) of a bank’s capital base?

That would, at the least, give CP lenders an incentive to preferentially provide funding to banks with less leverage so that leverage would be roughly equalised across the industry.

But it might also present an improved framing of lending decisions: By guaranteeing short-term debt up to, say, 2x tier1 capital, the Fed draws attention to the fact that further lending will dilute the coverage.

Posted by jb | Report as abusive
 

William Poole’s (retired president of StL fed) idea for strengthening the banking system is the opposite. Force banks to hold 10% of liabilities in 10year subordinated notes.
http://www.cato.org/pub_display.php?pub_ id=10241

Posted by winstongator | Report as abusive
 

You do understand that not all bankruptcies are liquidations? There is the reorganizational Chapter 11 code. I’m just going to assume you included yourself in the collective “One” when cautioning the world on misrepresenting bankruptcy.

“One has to be careful when using the term ‘bankruptcy’ with respect to banks”

Banks have capital structures that can be bought, sold and reorganized just like any other business.

Posted by hello | Report as abusive
 

U.S. banks don’t file for bankruptcy, Felix. They’re resolved by the FDIC. Do you seriously not know this yet?

And no, the government does not have the authority to force debt-for-equity swaps under its existing resolution authority (bankrupcy code or FDI Act). But that hasn’t stopped supposedly serious people from claiming, without a hint of irony, that this is what the government SHOULD have done.

Posted by A&O | Report as abusive
 

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