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Stock market circuit breakers halt trading activity on a single stock or an entire exchange if a sudden large price move occurs. Their purpose is to forestall cascading trading activity caused by gaps in liquidity or order errors. Whether circuit breakers achieve this goal is contentious. This post adds to the debate by analyzing intraday price formation on the Tokyo Stock Exchange (TSE) on May 23, 2013—the pinnacle of this past year’s volatility in Japanese stock markets. While no circuit breakers were triggered on the TSE, we focus on trading conditions before and after the daily lunch break, which halted trading amid heightened market volatility on that day. The data seem to indicate that the break did not stem price volatility; rather, its anticipation may have worsened trading conditions.
How does any firm decide on its capital structure—how much equity (capital) to use, how much debt? And what does research tell us about why banks have so much more financial leverage than other firms? How does this inform capital regulation? This post provides a fresh perspective on these questions, identifying the forces that shape the privately optimal capital structure choices of banks, the manner in which government safety nets distort these choices, and how capital regulation ought to be redesigned in light of these distortions. In particular, we discuss a novel approach (developed in Acharya, Mehran, and Thakor ) to capital regulation that involves a two-tier capital requirement as well as how such a requirement can enhance banking stability.
This post is the thirteenth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
The motivation for the Economic Policy Review series was to understand better the behavior of large and complex banks, and we have covered a lot of ground toward that end. We have examined large banks’ economies of scale, their proclivity toward risk taking, their possible funding advantages (pre-Dodd Frank), the sources and types of their complexity, and the sources and means of dealer bank financing. We have also looked at resolution issues surrounding large and complex banks, including a case study on the Lehman bankruptcy, a review of resolution methods, and two studies of the rationale for a long-term debt requirement for large and complex banks (bail-in), which could provide a source of loss absorbency in resolution. In this post, we provide our own thoughts on what the series has taught us.
James McAndrews, Donald P. Morgan, Joao Santos, and Tanju Yorulmazer
This post is the twelfth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
If the Lehman Brothers failure proved anything, it was that large, complex bank failures are messy; they destroy value and can destabilize financial markets. We certainly don’t mean to trivialize matters by calling large bank failures “messy,” as it their messiness, particularly the destabilizing aspect, that creates the “too-big-to-fail” problem. In our contribution to the Economic Policy Review volume, we venture an explanation about why large bank failures are so messy and discuss a policy that can make them less so.
This post is the eleventh in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
“[T]he instinct of the trader does somehow anticipate the conclusions of the closet.”
Walter Bagehot is always good for an epigraph. And this epigraph is a good one: going well beyond traders. It also applies to the conjoint instinct of bankers, legislators, and regulators. The “bail-in,” or “single point of entry,” technique of large bank insolvency was conceived by bankers, authorized by Congress, and is being implemented by the FDIC. (Calello and Ervin (2010); 12 USC § 5381 et seq.; Single Point of Entry Strategy). This nascent practice needs a conceptual framework. This post, and the companion article in the Economic Policy Review, suggests one. The framework does more than justify bail-in. It applies more generally to financial firm insolvency. It also provides a new and surprising perspective on bank capital.
This post is the tenth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks.For more on this topic, see this special issue of the Economic Policy Review.
The bankruptcy of Lehman Brothers and its 209 registered subsidiaries was one of the largest and most complex in history, with more than $1 trillion of creditor claims in the United States alone, four bodies of applicable U.S. laws, and insolvency proceedings that involved over eighty international legal jurisdictions. The experience of resolving Lehman has led to an active debate regarding the effectiveness of applying the U.S. Chapter 11 Bankruptcy Code to complex financial institutions. In this post, we draw on our Economic Policy Review article to highlight the challenges of resolving Lehman in the U.S. Bankruptcy Court.
This post is the ninth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
During the recent crisis, some of the largest and most prominent financial institutions failed or nearly failed, requiring extraordinary intervention from regulators, such as extended access to lender-of-last-resort facilities, debt and deposit guarantees, and injection of capital to mitigate systemic risk. Banks and other financial intermediaries perform important functions, such as channeling resources from savers to productive projects and providing payment services to customers through their money-like liabilities. Hence, their failure can disrupt the economy, and an efficient resolution mechanism can mitigate those disruptions. In our contribution to the Economic Policy Review volume, Phoebe White and I develop a simple framework to analyze resolution of failed banks. First, we discuss the costs associated with the failure and resolution of banks. Then, we review resolution policies used by authorities and analyze the optimality of resolution options. Our main message is that the optimality and the feasibility of resolution options depend not only on the characteristics of the failed bank itself, but also on the health of the entire banking system, which warrants a macroprudential approach.
Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed
This post is the eighth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
The failure or near-collapse of some of the largest dealer banks on Wall Street in 2008 highlighted the profound complexity of the industry. In some ways, dealer banks resemble well-understood traditional banks, which use deposits they receive from savers to make loans to businesses and households. Unlike traditional banks, however, dealer banks rely on complex and unique forms of collateralized borrowing and lending, which often involve the simultaneous exchange of cash and securities with other large and sophisticated financial institutions. During normal times, such transactions are highly efficient methods for allocating scarce resources. During times of stress, in contrast, they’ve proven to be destabilizing for the individual firms and, as recent history has shown, the financial system at large.
Liberty Street Economics features insight and analysis from economists working at the intersection of research and policy. The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan.
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