Government & Politics , Finance & Investing

How Big Banks Fail and What to Do about It

A finance professor says putting the financial system in order depends on understanding of how big banks can go from weakness to sudden failure.

July 01, 2010

| by Stanford GSB Staff

In a forthcoming book, Stanford Graduate School of Business finance expert Darrell Duffie goes behind the scenes to describe the financial network of incentives and financial contracts that lead to run-on-the-bank calamities during the financial crisis of 2007-2009. He argues that success in placing the global financial system on a sounder footing going forward 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.

In How Big Banks Fail and What To Do About It, to be published by Princeton University Press in July, Duffie, the Dean Witter Distinguished Professor of Finance, describes the failure mechanics of dealer banks in clinical detail. He also outlines 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. The dealer banks are at the center of the plumbing of the financial system. Among 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 along the backbone of the financial system.

Once the solvency of a dealer bank is questioned, its relationships with its customers, equity investors, secured creditors, derivatives counterparties, and clearing bank can change suddenly. The incentives at play are similar to those of a depositor run at a commercial bank. That is, fear over the solvency of the bank leads to a rush by many to reduce their potential losses in the event that the bank fails. At first, the bank must signal its strength, giving up some of its slim stocks of remaining capital and cash, for to do otherwise would increase perceptions of weakness. Finally, it is impossible for the bank to stem the tide of cash outflows. The bank fails.

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, 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, writes Duffie. Some of the required reforms are among those suggested in 2009 by the Basel Committee on Banking Supervision and in the U.S. 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.

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