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How Big Banks Fail and What to Do about It

How Big Banks Fail and What to Do about It

Darrell Duffie
Copyright Date: 2011
Pages: 112
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  • Book Info
    How Big Banks Fail and What to Do about It
    Book Description:

    Dealer banks--that is, large banks that deal in securities and derivatives, such as J. P. Morgan and Goldman Sachs--are of a size and complexity that sharply distinguish them from typical commercial banks. When they fail, as we saw in the global financial crisis, they pose significant risks to our financial system and the world economy.How Big Banks Fail and What to Do about Itexamines how these banks collapse and how we can prevent the need to bail them out.

    In sharp, clinical detail, Darrell Duffie walks readers step-by-step through the mechanics of large-bank failures. He identifies where the cracks first appear when a dealer bank is weakened by severe trading losses, and demonstrates how the bank's relationships with its customers and business partners abruptly change when its solvency is threatened. As others seek to reduce their exposure to the dealer bank, the bank is forced to signal its strength by using up its slim stock of remaining liquid capital. Duffie shows how the key mechanisms in a dealer bank's collapse--such as Lehman Brothers' failure in 2008--derive from special institutional frameworks and regulations that influence the flight of short-term secured creditors, hedge-fund clients, derivatives counterparties, and most devastatingly, the loss of clearing and settlement services.

    How Big Banks Fail and What to Do about Itreveals why today's regulatory and institutional frameworks for mitigating large-bank failures don't address the special risks to our financial system that are posed by dealer banks, and outlines the improvements in regulations and market institutions that are needed to address these systemic risks.

    eISBN: 978-1-4008-3699-4
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. List of Figures and Tables
    (pp. ix-x)
  4. Preface
    (pp. xi-xvi)
    Darrell Duffie
  5. CHAPTER ONE Introduction
    (pp. 1-8)

    I begin with a story of the failure of a bank that is a major dealer in securities and derivatives. Our dealer bank will be unable to stop the drain of cash caused by the departures of its short-term creditors, over-the-counter (OTC) derivatives counterparties, and client hedge funds. The most immediate examples are the 2008 failures of Bear Stearns and Lehman, but the failure mechanics at work could apply to any major dealer bank, once it is sufficiently weakened. There are further lessons to be learned from the major dealers such as Morgan Stanley that did not fail despite severe...

  6. CHAPTER TWO What Is a Dealer Bank?
    (pp. 9-22)

    Dealer banks are financial institutions that intermediate the “backbone” markets for securities and over-the-counter (OTC) derivatives. These activities tend to be bundled with other wholesale financial market services, such as prime brokerage and underwriting. Because of their size and their central position in the plumbing of the financial system, the failure of a dealer bank could place significant stress on its counterparties and clients, and also on the prices of the assets or derivatives that it holds. The collapse of a major dealer bank also reduces the ability of the financial system to absorb further losses and to provide credit...

  7. CHAPTER THREE Failure Mechanisms
    (pp. 23-42)

    The relationships between a dealer bank and its derivatives counterparties, potential debt and equity investors, clearing bank, and clients can change rapidly if the solvency of the dealer bank is threatened. A dealer’s liquidity can suddenly disappear, as illustrated in figure 3.1, which shows how quickly Bear Stearns’s cash resources were depleted once its solvency came into question in March 2008. As explained in chapter 1, the concepts at play are not so different from those involved in a depositor run.

    In this chapter, we describe the main processes by which a run on a dealer can occur, through OTC...

  8. CHAPTER FOUR Recapitalizing a Weak Bank
    (pp. 43-52)

    This chapter reviews some impediments to the prefailure recapitalization of a weakened systemically important financial institution, such as a major dealer bank. It also explores two “automatic” recapitalization mechanisms. The first is distress-contingent convertible debt, which consists of claims to interest and principal that automatically convert to shares of equity if and when the financial institution fails to meet a stipulated capital requirement. The second mechanism is a regulation mandating an offer to existing shareholders to purchase new equity at a low price when a financial institution fails to meet a stipulated liquidity or capital requirement. These relatively new approaches...

  9. CHAPTER FIVE Improving Regulations and Market Infrastructure
    (pp. 53-62)

    In this last chapter, I summarize some policies for improving the robustness of the financial system by increasing the financial stability of large dealer banks. In the past, these banks have often been deemed “too big to fail.” Although various new sources of government liquidity and capital that appeared during the financial crisis of 2007–2009 may have prevented some extremely damaging failures, some of these new government programs may turn out to be costly to taxpayers and could increase moral hazard in the risk-taking of large dealer banks going forward, absent other measures.

    Here, I focus on the strengthening...

  10. APPENDIX Central Clearing of Derivatives
    (pp. 63-70)
  11. Notes
    (pp. 71-78)
  12. Bibliography
    (pp. 79-86)
  13. Index
    (pp. 87-91)