Advisory Center for Affordable Settlements & Housing

acash

Advisory Center for Affordable Settlements and Housing
ACASH

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Document TypeGeneral
Publish Date17/03/2010
Author
Published ByPrinceton University Press.
Edited ByTabassum Rahmani
Uncategorized

How Big Banks Fail And What to do About It

Coming out of the financial crisis of 2007-2009, success in placing our financial system on a sounder footing depends on an understanding of how the largest and most connected banks, the major dealer banks, can make a sudden transition from weakness to failure. The dealer banks are at the center of the plumbing of the financial system. Among many other crucial activities, they intermediate over-the-counter markets for securities and derivatives. Although the financial crisis has passed, the dealer banks remain among the most serious points of weakness in the backbone of the financial system.

The key mechanisms of a dealer-bank failure, such as the collapses of Bear Stearns and Lehman Brothers in 2008, depend on special institutional and regulatory frameworks that influence the flight of short-term secured creditors, hedge-fund clients, and derivatives counter-parties, and most devastatingly, the loss of clearing and settlement services. Dealer banks, sometimes referred to as “large complex financial institutions” or as “too big to fail,” are indeed of a size and complexity that sharply distinguish them from typical commercial banks. Even today, the failure of a dealer bank would pose a significant risk to the entire financial system and the wider economy. Current regulatory approaches to mitigating bank failures do not adequately treat the special risks posed by dealer banks. Some of the required reforms are among those suggested in 2009 by the Basel Committee on Banking Supervision (2009) and in pending U.S. legislation, the Restoring American Financial Stability Bill. Other needed reforms to regulations or market infrastructure still do not receive adequate attention. A January 2010 speech by Paul Tucker, Deputy Governor of the Bank of England, shows that some regulators are aware of the significant changes still required.1InHow Big Banks Fail, I describe the failure mechanics of dealer banks in clinical detail, and outline improvements in regulations and market infrastructure that are likely to reduce the risks of these failures and reduce the damage they cause to the wider financial system when they do fail (Tucker (2010).

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