Report
Teaser, summary, work performed and final results
Periodic Reporting for period 2 - TBTF (Addressing Too Big to Fail: Resolution, Organizational Structure, and Funding of Global Banks)
Teaser
One of the main unresolved challenges of the recent financial crisis is how society should deal with global financial institutions that are “too big to fail.†The collapse of Lehman Brothers vividly demonstrated the costs of the failure of such an institution, with...
Summary
One of the main unresolved challenges of the recent financial crisis is how society should deal with global financial institutions that are “too big to fail.†The collapse of Lehman Brothers vividly demonstrated the costs of the failure of such an institution, with sweeping repercussions for the financial system and the broader economy. Yet, implicit public guarantees that would prevent such failures are equally costly, creating moral hazard in the form of increased risk taking and incentives for financial institutions to become larger and more complex.
The research undertaken under this grant addresses this dilemma. From a methodological perspective, the research advances the state of the art in financial intermediation theory by explicitly modeling the failure and resolution of global banks, emphasizing elements that are absent from leading theories: the design of mechanisms that allow for an orderly resolution of struggling global financial institutions, the incentives of national authorities in the regulation and resolution of global banks, the role of the corporate and organizational structure of global banks, as well as their size, scope, and complexity. The proposed approach is interdisciplinary; it will generate novel insights by drawing on different subfields within economics (corporate finance theory, organizational economics) and aspects of bankruptcy law. Moreover, the research takes holistic view that explicitly recognizes the two-way feedback between the rules that govern bank resolution and decisions on funding, investment, and structure taken by banks prior to a potential resolution. Overall, the findings from this research will be directly relevant for regulators and policymakers. For example, they will inform currently debated legislation regarding the regulation and resolution of global banks, such as the Single Resolution Mechanism in the EU.
Work performed
The first 30 months of this grant has resulted in two peer-reviewed publications. The paper “Bank Resolution and the Structure of Global Banks†develops an analytical framework to assess the economic trade-offs that arise when choosing between alternative bank resolution models that have been proposed to address too big to fail (TBTF). The paper (1) characterizes the main economic trade-off between the two archetypal resolution methods, single point of entry (SPOE) and multiple point of entry (MPOE), (2) analyzes constrained-optimal bank resolution and relates those findings to the debate on “prepositioning†of loss-absorbing capital, (3) explores the feedback between bank resolution and bank structure, and (4) characterizes the effect of the chosen resolution method on the incentives of bank managers. The paper “A Theory of Multiperiod Debt Structure†develops a general but tractable theory of optimal multiperiod debt financing. This paper advances the state of the art by offering a unified framework to study issues related to the choice of debt maturity and debt granularity by banks and corporations. In doing so, the paper enhances our understanding of what determines debt structure.
Final results
Ongoing research under this grant investigates (1) the optimal and equilibrium complexity of financial products and institutions, (2) the ability of socially responsible investors to reduce systemic externalities and other social costs caused by banks and other firms, and (3) the causes and consequences of the rise of large global banks.