A proposal for efficiently resolving out-of-the-money swap positions at large insolvent banks
Abstract: Recent evidence suggests that bank regulators appear to be able to resolve insolvent large banks efficiently without either protecting uninsured deposits through invoking "too-big-to-fail" or causing serious harm to other banks or financial markets. But resolving swap positions at insolvent banks, particularly a bank's out-of-the-money positions, has received less attention. The FDIC can now either repudiate these contracts and treat the in-the-money counterparties as at-risk general creditors or transfer the contracts to a solvent bank. Both options have major drawbacks. Terminating contracts abruptly may result in large-fire sale losses and ignite defaults in other swap contracts. Transferring the contracts both is costly to the FDIC and protects the counterparties, who would otherwise be at-risk and monitor their banks. This paper proposes a third option that keeps the benefits of both options but eliminates the undesirable costs. It permits the contracts to be transferred, thus avoiding the potential for fire-sale losses and adverse spillover, but keeps the insolvent bank's in-the-money counterparties at-risk, thus maintaining discipline on banks by large and sophisticated creditors.
File(s): File format is application/pdf http://www.chicagofed.org/digital_assets/publications/working_papers/2003/wp2003-01.pdf
Provider: Federal Reserve Bank of Chicago
Part of Series: Working Paper Series
Publication Date: 2003