Economic Policy Review
What Makes Large Bank Failures So Messy and What Should Be Done about It?
2014 Volume 20, Number 2
JEL classification: G20, G28, G01
Donald P. Morgan,
João A. C. Santos, and
This study argues that the defining feature of large and complex banks that makes their failures messy is their reliance on runnable financial liabilities. These liabilities confer liquidity or money-like services that may be impaired or destroyed in bankruptcy. To make large bank failures more orderly, the authors recommend that systemically important bank holding companies be required to issue “bail-in-able” long-term debt that converts to equity in resolution. This reassures holders of uninsured liabilities that their claims will be honored in resolution, making them less likely to run. In a novel finding, the authors show that bail-in-able debt and equity are not perfect substitutes in terms of stemming bank runs. Finally, they argue that the long-term debt requirement should increase in line with the amount of uninsured financial liabilities the bank has issued. This approach has the advantage of tying the requirement to the sources of messy failures, and it tends to internalize the externalities associated with the issuance of uninsured financial liabilities.