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Dealing with the Lehman problem - US-UK ideas on resolving large banks offer way forward

Financial Times, December 11, 2012

When Lehman Brothers collapsed four years ago, the shockwaves that followed exposed hidden faultlines in the financial system and provoked bank rescues around the world.  Ever since, regulators have been mulling over how to amend the rules so that, in future, the collapse of large institutions will not spread such trauma.

A new paper authored by the Bank of England and the Federal Deposit Insurance Corporation of the US explains how they might in future deal with a Lehman-scale problem were one to occur at a global systemically important financial institution (“GSifi”). Their words carry weight: 12 of the world’s 28 GSifis are based in Britain or the US.

To prevent panic spreading, as it did when Lehman’s subsidiaries fell into bankruptcy in different jurisdictions, the failing institution would be placed in a single resolution regime at the level of its holding company. This would then take control of the group, fire management, write down the shareholders and, if needed, force bondholders to recapitalise it by swapping bonds for equity, thus avoiding a taxpayer rescue. The group would then be returned to private hands as a solvent institution.

Going in at the holding company level to resolve large multinational banks makes sense. Just a single intervention is required, potentially speeding the process and reducing the uncertainty for creditors. It is also a reflection of the reality. Banks are, as Mervyn King, BoE governor, once observed, “international in life but national in death”.

For this to be feasible, however, many banks may have to rejig their finances. Notably, bank holding companies would need to be capitalised with sufficient equity and long-term bail-in-able debt to make it possible to resolve the group in all conceivable circumstances. Financing could no longer be driven by tax or regulatory advantage, as in the past.

None of this is likely to be popular with banks. The requirement to hold more bail-in-able debt would probably raise their cost of capital, while extra capitalisation at the holding company level would reduce their ability to use leverage. The proposals also strengthen the case for the ringfencing or separation of retail subsidiaries.

But if the world is to move on from the crisis, a way must be found to deal with the risks posed by very large universal and investment banking groups. The US-UK proposals offer a sensible step forward in this endeavour. In that spirit, they should be welcomed.

Last Updated 12/9/2012 communications@fdic.gov