This post is the twelfth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks.
If the Lehman Brothers failure proved anything, it was that large, complex bank failures are messy; they destroy value and can destabilize financial markets. We certainly don’t mean to trivialize matters by calling large bank failures “messy,†as it their messiness, particularly the destabilizing aspect, that creates the “too-big-to-fail†problem. In our contribution to the Economic Policy Review volume, we venture an explanation about why large bank failures are so messy and discuss a policy that can make them less so.
Uninsured Financial Liabilities
Our explanation of why large, complex bank failures are so messy hinges around the concept of uninsured financial liabilities (UFLs). UFLs are liabilities that are issued mainly by financial firms—think uninsured deposits or repos, for example. A bond is not a financial liability because large, nonfinancial firms can, and of course do, issue bonds. We borrowed the concept of UFLs from Joe Sommer, whose postappeared yesterday.
Very large banks are very reliant on UFLs, as the chart below shows. UFLs represent less than 22 percent of liabilities for bank holding companies (BHCs) in the 1st-9th asset decile, but over 40 percent of liabilities for BHCs in the largest decile.
In passing, note that we’re counting commercial paper (CP) in the UFL bucket (even though nonbanks also issue CP) because banks tend to make markets in their own CP, which makes it more like a deposit (than CP issued by large, nonfinancial firms).
UFLs have two properties that contribute to messy failures. First, they provide liquidity or risk sharing that gets destroyed in bankruptcy; that adds to the cost of large bank failures. Second, they’re runnable. As UFL holders run, the bank must borrow to replace the funding it loses to the run or sell assets quickly. The asset sales can lead to deeply discounted prices (that is, fire sales), further imperiling the solvency of the bank and imposing costs on other banks with similar assets. In addition, because other financial institutions demand uninsured financial liabilities from banks because of their money-like properties, the failure of the issuing bank can bankrupt the institutions holding its liabilities (apart from fire sales). The leading example, of course, is the Reserve Primary Fund; that money market fund “broke the buck†after Lehman filed for bankruptcy because it was holding $535 million of Lehman’s commercial paper.
