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A proposal for efficiently resolving out-of-the-money swap positions at large insolvent banks

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  • George G. Kaufman

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.

Suggested Citation

  • George G. Kaufman, 2003. "A proposal for efficiently resolving out-of-the-money swap positions at large insolvent banks," Working Paper Series WP-03-01, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-03-01
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    References listed on IDEAS

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    1. Allen N. Berger & Gregory F. Udell, 2002. "Small Business Credit Availability and Relationship Lending: The Importance of Bank Organisational Structure," Economic Journal, Royal Economic Society, vol. 112(477), pages 32-53, February.
    2. Kaufman, George G., 2002. "Too big to fail in banking: What remains?," The Quarterly Review of Economics and Finance, Elsevier, vol. 42(3), pages 423-436.
    3. Alan Greenspan, 2001. "The financial safety net," Proceedings 701, Federal Reserve Bank of Chicago.
    4. George G. Kaufman & Steven A. Seelig, 2002. "Post-resolution treatment of depositors at failed banks: implications for the severity of banking crises, systemic risk, and too big to fail," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 26(Q II), pages 27-41.
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    Cited by:

    1. Harrison, Ian & Anderson, Steve & Twaddle, James, 2007. "Pre-positioning for effective resolution of bank failures," Journal of Financial Stability, Elsevier, vol. 3(4), pages 324-341, December.
    2. Bliss, Robert R. & Kaufman, George G., 2006. "Derivatives and systemic risk: Netting, collateral, and closeout," Journal of Financial Stability, Elsevier, vol. 2(1), pages 55-70, April.
    3. Robert R. Bliss & George G. Kaufman, 2005. "Derivatives and systemic risk: netting, collateral, and closeout," Working Paper Series WP-05-03, Federal Reserve Bank of Chicago.

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    Keywords

    Deposit insurance; Federal Deposit Insurance Corporation; Swaps (Finance);
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