How to deal with financial institutions deemed too big to fail
Not only did the collapse of Lehman Brothers in 2008 start a global financial crisis, it also gave the world a new term: ‘too big to fail’. “This term refers to businesses or sectors considered to be so essential to the economy that their failure would have disastrous consequences,” says Martin Oehmke, a professor at the London School of Economics and Political Science. “How to deal with financial institutions that are too big to fail was one of the key unresolved challenges of the post-Lehman world.” With support from the EU-funded TBTF project, Oehmke has developed theoretical models geared towards helping us better understand how to address ‘too big to fail’ and other externalities caused by financial institutions and corporations. “The starting point of the project was how to design appropriate resolution frameworks so financial institutions can fail without imposing significant costs on society,” he explains. “In addition, I wanted to shed light on how financial institutions and other corporations choose their debt structure and how investors can influence banks and companies to behave in a more socially responsible manner.”
Prize-winning research
The models Oehmke developed succeeded in producing several important insights. For example, one challenge in resolving financial institution issues is that, although a bank is global, national authorities are in charge of resolution. “In designing a resolution framework, one therefore must carefully consider the national interests that come into play when a global financial institution is collapsing,” notes Oehmke. “In short, an effective resolution framework has to match the business risks and organisational structure of a financial institution.” Starting from ‘too big to fail’, it was a natural next step to address more general externalities caused by banks and corporations. “One key area is the role that socially responsible investors can play in this dimension,” remarks Oehmke. His research on this topic, which won the European Finance Association’s prize for best paper on sustainable finance, suggests that investor engagement is more promising than divesting from the company.
Climate change and global financial institutions
Beyond traditional financial risks, the project also looked at how climate change could impact global financial institutions. In particular, Oehmke examined whether climate-related risks and externalities can be addressed via bank regulation. “My research shows that capital regulation can help the banking sector withstand financial risks that result as a consequence of climate change, such as extreme weather events,” he adds. “However, capital regulation is much less effective at addressing carbon emissions, the root cause of climate change.”
Research is already guiding policy
While Oehmke’s research may be theoretical, it is already having a real impact. “I always want my research to guide policy,” he says. “From this perspective, this project has been very successful.” Oehmke has presented his findings to several financial regulators, including the EU’s Single Resolution Board. He recently presented his work on capital regulation and climate change to the European Systemic Risk Board. “I hope that the results of this European Research Council project will help EU institutions make good policy decisions and address some of the most pressing issues we face as a society,” concludes Oehmke. Even though the TBTF project is now finished, Oehmke’s research is not. He is currently studying the interplay between financial regulation and environmental regulation and how they might have to work together to reduce carbon emissions.
Keywords
TBTF, financial institutions, too big to fail, Lehman Brothers, economy, corporations, debt structure, banks, socially responsible investor, sustainable finance, climate change, bank regulation