Liberty Street Economics
April 07, 2014

A New Idea on Bank Capital

Hamid Mehran and Anjan Thakor

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 [2013]) to capital regulation that involves a two-tier capital requirement as well as how such a requirement can enhance banking stability.

Posted by Blog Author at 7:00 AM in Financial Institutions | Permalink | Comments ( 2 )

April 04, 2014

Parting Reflections on the Series on Large and Complex Banks

James McAndrews and Donald P. Morgan

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.

Posted by Blog Author at 7:02 AM in Financial Institutions | Permalink | Comments ( 0 )

Why Large Bank Failures Are So Messy and What to Do about It?

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.


Posted by Blog Author at 7:00 AM in Financial Institutions | Permalink | Comments ( 1 )

April 03, 2014

Why Bail-in?

Joseph H. Sommer

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.

Posted by Blog Author at 7:02 AM in Financial Institutions | Permalink | Comments ( 3 )

The Failure Resolution of Lehman Brothers

Michael Fleming and Asani Sarkar

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.


April 02, 2014

Resolution of Failed Banks

Tanju Yorulmazer

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.


Posted by Blog Author at 7:00 AM in Financial Institutions | Permalink | Comments ( 0 )

April 01, 2014

Mixing and Matching Collateral in Dealer Banks

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.

March 31, 2014

Measuring Global Bank Complexity

Nicola Cetorelli, Linda Goldberg, and Arun Gupta

This post is the seventh 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.

Paraphrasing a famous Supreme Court opinion: “I know bank complexity when I see it.” This expression probably speaks to the truth that, if we look at a given banking organization, we ought to be able to state whether it is more or less “complex.” And yet, such an approach hardly offers any guidance if one wants to understand the intricacies of global banks and to monitor and regulate them. What should be the appropriate metrics? It seems to us that there is not a consensus just yet on what complexity might mean in the context of banking. The global dimension of a bank adds many layers, so focusing on global banks is bound to yield a more comprehensive take on the issue than examining purely domestic banking entities. Therefore, in this piece, we view complexity through the lens of the operations of global banks.

March 28, 2014

Evolution in Bank Complexity

Nicola Cetorelli, James McAndrews, and James Traina

This post is the sixth 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.

In yesterday’s post, our colleagues discussed the historic changes in financial sector size. Here, we tackle a related question on dynamics—how has bank complexity evolved through time? Recently, academics and policymakers have proposed a variety of strong actions to curb bank complexity, stemming from the view that complex banks are undesirable. While the large banks of today are certainly complex, we lack a thorough understanding of how they got that way. In this post and in our related contribution to the Economic Policy Review (EPR) volume, we focus on organizational complexity, measured by the number and types of entities organized together under common ownership and control. Using a new data set of financial-sector acquisitions, we study the structural evolution of banks and its implications for policy. We argue that banks grew into increasingly complex conglomerates in adaptation to a changing financial sector.


Posted by Blog Author at 7:00 AM in Financial Markets | Permalink | Comments ( 1 )

March 27, 2014

The Growth of Murky Finance

Samuel Antill, David Hou, and Asani Sarkar

This post is the fifth 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.

Building upon previous posts in this series that discussed individual banks, we examine the historical growth of the entire financial sector, relative to the rest of the economy. This sector’s historically large share of the economy today (see chart below) and its role in disrupting the functioning of the real economy during the recent financial crisis have led to questions about the social value of costly financial services. While new regulations such as the Dodd-Frank Act impose restrictions on financial activities and increase their costs, especially those of large firms, our paper  suggests that there may be limits to what regulation can achieve. In particular, we show that financial growth has occurred in the more opaque and harder to regulate sectors: private firms, shadow banks, and small nonbank financial firms. Moreover, we find that the stock market values these opaque areas of finance more, suggesting that they may expand even faster in the future.

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