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Who Will Carry the Water?

By Thomas Cooley, Paganelli-Bull Professor of Business and International Trade, and Kermit Schoenholtz, Professor of Management Practice and Director of the Center for Global Economy and Business

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In a full-fledged systemic crisis, involving a shortfall of capital in the financial sector as a whole, the instrument holder would be selling rainy-day insurance to the entire financial system.

To make the U.S. financial system safe, we need to end the era of big bailouts. In December, the U.S. and the UK took a significant step in that direction, announcing a common strategy for resolving insolvent cross-border financial giants, known as global systemically important financial intermediaries (G-SIFIs).

In spite of this progress and the Dodd-Frank law notwithstanding, the specter of 'too big to fail' still haunts the financial landscape. It is hard to imagine that a future U.S. Treasury Secretary would risk another Lehman crisis by imposing large losses on a behemoth's creditors, let alone sacrificing several financial giants in a systemic crisis. Such doubts tilt the financial playing field in favor of big intermediaries, which receive a subsidy in the form of lower funding costs (and higher credit ratings) due to this perceived insurance.

Cross-border entanglements make it difficult to resolve a G-SIFI without a crisis. When Lehman failed, it had nearly three thousand legal entities in fifty countries. Such cross-border operations trigger complex interactions between the bankruptcy procedures of multiple countries, encouraging a self-defeating grab race for assets by regulators and counterparties alike. Large, unnecessary -- and potentially crisis-triggering -- losses are likely to result.

Read full article as published in The Huffington Post