E Pluribus Unum: single vs. multiple point of entry resolution

Addressing the calamity posed by the failure of large, global financial intermediaries has been high on the post-crisis regulatory reform agenda. When Lehman Brothers―a $600 billion entity―failed, it took heroic efforts by the world’s central bankers to prevent a financial meltdown. The lesson is that a robust resolution regime is a critical element of a resilient financial system.

Experts have been hard at work implementing a new mechanism so that the largest banks can continue operation, or be wound down in an orderly fashion, without resorting to taxpayer solvency support and without putting other parts of the financial system in danger. To enhance market discipline, the shareholders that own an entity and the bondholders that lent to it must face the consequences of poor performance.

How can we ensure that healthy operating subsidiaries of G-SIBs continue to serve their customers even during resolution? Authorities have proposed a solution that takes two forms: “single point of entry (SPOE)” and “multiple point of entry (MPOE).” A key difference between these two resolution methods is that the former allows for cross-subsidiary sharing of loss-absorbing capital and cross-jurisdictional transfers during resolution, while the latter does not. The purpose of this post is to describe SPOE and MPOE. We highlight both the relative efficiency of SPOE and the requirements for its sustainability: namely, adequate shared resources, an appropriate legal framework and a credible commitment among national resolution authorities to cooperate….

FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

Commentary

Money, Banking, and Financial Markets