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Addressing Too Big to Fail: Resolution, Organizational Structure, and Funding of Global Banks

Periodic Reporting for period 4 - TBTF (Addressing Too Big to Fail: Resolution, Organizational Structure, and Funding of Global Banks)

Période du rapport: 2021-06-01 au 2022-05-31

One of the main unresolved challenges posed by the financial crisis of 2008 is how society should deal with potential failures of financial institutions that are “too big to fail” and, thereby, impose negative systemic externalities on society. The collapse of Lehman Brothers vividly demonstrated the immense costs of the failure of such an institution, with sweeping repercussions for the financial system and the broader economy. More broadly, how can financial regulators and market participants address externalities generated by firms and financial institutions? TBTF aims to answer these questions, thereby providing conceptual foundations to help policymakers address some of society’s most pressing issues, from financial stability to dealing with climate risks and the carbon transition.

The research undertaken as part of TBTF has developed new theoretical frameworks to answer these questions, offering concrete guidance to researchers and policymakers. From a methodological perspective, this research has advanced 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, the complexity of their regulation, and the determinants of their debt structure. The research has also generated significant insights into how investors can induce banks and firms to behave more responsibly and has investigated the ability of bank regulators to address climate-related financial risks and carbon externalities.

The objective of TBTF is to generate novel research insights that are directly relevant to regulators and policymakers, such as the EU’s Single Resolution Board and the European Central Bank.
The project’s starting point and foundation was the development of a novel model to study the resolution of global banks that are “too-big-to-fail” so that their failure would impose significant costs on society, as exemplified by the collapse of Lehman Brothers in 2008. The article “Bank Resolution and the Structure of Global Banks” (Review of Financial Studies, 2019) shows that credible resolution regimes need to take into account the interests of national resolution authorities (for example, they may refuse to make large transfers to other jurisdictions during a resolution). Moreover, they need to reflect the organizational structure and risk profile of the global financial institution. In terms of concrete policy guidance, these results show that resolution is not “one-size-fits-all” and provides a taxonomy of which institutions can be resolved effectively under competing models, such as single-point-of-entry and multiple-point-of-entry resolution. Alongside the work on resolution, the research team developed a new model of the determinants of the debt structure chosen by firms and financial institutions (“A Theory of Multi-Period Debt Structure,” Review of Financial Studies 2019). This research shows how debt structure (i.e. the timing, number, and amount of the promised debt repayments) is determined by a simple trade-off between the termination threat required to make repayments incentive compatible and the desire to avoid early liquidation, helping us understand observed empirical patterns of debt maturity profiles.

Project research then turned to other ways financial regulators and market participants can address externalities generated by firms and financial institutions. One key finding in the article “A Theory of Socially Responsible Investment” (currently R&R at Review of Economics Studies) is that investors can indeed induce banks or firms to behave more responsibly. However, doing so requires that socially responsible investors who engage with a company are willing to make a financial sacrifice. This article also develops an investment criterion, the Social Profitability Index, to help guide the allocation of socially responsible capital. The article “Green Capital Requirements” turns to whether bank regulators can address risks and externalities resulting from climate change. The key finding of this research is that capital regulation can help the banking sector withstand financial risks resulting from climate change, such as extreme weather events, but is much less effective at addressing carbon emissions. Finally, the article “The Tragedy of Complexity” turns to the complexity of financial regulation (and other market outcomes). The setting reflects a typical situation for global banks: they deal with multiple regulators for different parts of their business (e.g. a bank capital regulator, a derivative markets regulator, etc.). This research shows that equilibrium regulation can become overly complex if each regulator considers only outcomes for its specific regulatory mandate. A more holistic view of the regulatory landscape could prevent this outcome.

The project’s research findings were disseminated via several channels, including seminar and conference presentations at academic institutions and presentations to policymakers (ECB, ESRB, Single Resolution Board, Bundesbank, Banque de France, Nederlandsche Bank, Federal Reserve, Office for Financial Research, etc.). To reach a broader audience, key research findings were also disseminated via several non-technical summaries (both written and video), some of which were geared towards interdisciplinary audiences (e.g. the Harvard Law School Forum). Some of the project’s research findings were presented to the ESRB General Board and summarized in an ESRB ASC Insight policy paper, reflecting that, as intended, the project’s research findings have already influenced policy. Finally, two project conferences were held at LSE to facilitate the dissemination and exchange of research findings and ideas.
Rather than developing new methodologies, TBTF generated significant advances by drawing on building blocks from theoretical corporate finance, banking theory, and microeconomics and applying them in novel contexts. The research was driven by policy questions, and each model was crafted to capture the institutional setting and fundamental economic forces for each of these questions.

For example, the research on bank resolution draws on the model of financing under asymmetric information proposed by Bolton and Freixas (2000) and extends this framework to capture the balance sheet of a systemic global bank. The model then adds relevant constraints, such as that national regulatory authorities are subject to domestic political economy constraints. Together, these ingredients allowed us to perform one of the first theoretical analyses of competing bank resolution frameworks and provide guidance for policymakers. The research on socially responsible investing innovates by extending a canonical corporate finance model (Holmström and Tirole, 1997) to include production externalities, such as systemic externalities caused by large financial institutions or carbon-emission externalities by industrial firms. The combination of these ingredients yields novel insights regarding the conditions under which investors can induce firms to “do good.”
PI at project conference
The PI

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