Why large bank failures are so messy and what to do about It?

We argue that the defining feature of large and complex banks that makes their failures messy is their reliance on runnable financial liabilities that confer liquidity or money-like services that may be impaired or destroyed in bankruptcy. To make large bank failures more orderly, we advocate that systemically important bank holding companies be required to issue “bail-inable” 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, we show that bail-inable debt and equity are not perfect substitutes in terms of stemming bank runs. Finally, we argue that the long-term debt requirement should be increasing in the amount of uninsured financial liabilities the bank has issued. This has the advantage of tying the requirement to the sources of messy failures, and it tends to internalize the externalities associated with issuance of uninsured financial liabilities.

“This paper is part of the mini conference on "The Future of Large Financial Institutions" at the 2014 fall meetings of the International Atlantic Economic Society.  Sessions on this and related themes are expected to be continued at the spring 2015 meetings in Milan and the fall 2015 meetings in Boston.”