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Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University's Graduate School of Business. He is the author of Dynamic Asset Pricing Theory and the coauthor of Credit Risk: Pricing, Measurement, and Management (both Princeton).

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"In How Big Banks Fail and What to Do about It, Darrell Duffie tackles one of the central but often neglected issues in building a more resilient financial system. Duffie has that rare combination--the rigor of the academy and knowledge of how the plumbing of the financial system works. Anyone interested in regulatory reform will need to engage with his thinking."--Paul Tucker, deputy governor, financial stability, Bank of England

"The book does an excellent job of explaining the institutional setting of big dealer banks and how things went wrong in the financial crisis. The issues are important and the policy suggestions sound. There is nothing quite like this out there."--Franklin Allen, University of Pennsylvania

"Darrell Duffie is one of the leading experts on the problem of large-bank failures. He focuses on issues not addressed elsewhere, but which are being talked about everywhere. This book scores in a big way."--Viral V. Acharya, New York University

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"In How Big Banks Fail and What to Do about It, Darrell Duffie tackles one of the central but often neglected issues in building a more resilient financial system. Duffie has that rare combination--the rigor of the academy and knowledge of how the plumbing of the financial system works. Anyone interested in regulatory reform will need to engage with his thinking."--Paul Tucker, deputy governor, financial stability, Bank of England

"The book does an excellent job of explaining the institutional setting of big dealer banks and how things went wrong in the financial crisis. The issues are important and the policy suggestions sound. There is nothing quite like this out there."--Franklin Allen, University of Pennsylvania

"Darrell Duffie is one of the leading experts on the problem of large-bank failures. He focuses on issues not addressed elsewhere, but which are being talked about everywhere. This book scores in a big way."--Viral V. Acharya, New York University

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How Big Banks Fail and What to Do about It

PRINCETON UNIVERSITY PRESS

Contents

List of Figures and Tables........................................................ixPreface...........................................................................xiChapter One Introduction.........................................................1Chapter Two What Is a Dealer Bank?...............................................9Chapter Three Failure Mechanisms.................................................23Chapter Four Recapitalizing a Weak Bank..........................................43Chapter Five Improving Regulations and Market Infrastructure.....................53Appendix Central Clearing of Derivatives.........................................63Notes.............................................................................71Bibliography......................................................................79Index.............................................................................87

Chapter One

I begin with a story of the failure of a bank that is a major dealer in securities and derivatives. Our dealer bank will be unable to stop the drain of cash caused by the departures of its short-term creditors, over-the-counter (OTC) derivatives counterparties, and client hedge funds. The most immediate examples are the 2008 failures of Bear Stearns and Lehman, but the failure mechanics at work could apply to any major dealer bank, once it is sufficiently weakened. There are further lessons to be learned from the major dealers such as Morgan Stanley that did not fail despite severe stresses on their liquidity shortly after the Lehman bankruptcy.

We pick up the story several months before the demise of a hypothetical dealer bank, which we shall call Beta Bank. Beta's capital position has just been severely weakened by losses. The cause need not be a general financial crisis, although that would further reduce Beta's chance of recovery. Once weakened, Beta takes actions that worsen its liquidity position in a rational gamble to signal its strength and protect its franchise value. Beta wishes to reduce the flight of its clients, creditors, and counterparties.

Beta's first move is to bail out some clients from the significant losses that they suffered through investments arranged by Beta. This is an attempt to maintain the value of Beta's reputation for serving its clients' interests. As time passes, and the cracks in Beta's finances become apparent to some market participants, Beta notices that some of its OTC derivatives counterparties have begun to lower their exposures to Beta. Their transactions slant more and more toward trades that drain cash away from Beta and toward these counterparties. Beta believes that it must continue to offer competitive terms on these trades, for to do otherwise would signal financial weakness, thereby exacerbating the flight. Other dealer banks are increasingly being asked to enter derivatives trades, called "novations," which have the effect of inserting the other dealers between Beta and its original derivatives counterparties, insulating those counterparties from Beta's default risk. As those dealers notice this trend, they begin to refuse novations that would expose them to Beta's default. As a result, the market gossip about Beta's weakness begins to circulate more rapidly.

Beta has been operating a significant prime-brokerage business, offering hedge funds such services as information technology, trade execution, accounting reports, and-more important to our story-a repository for the hedge funds' cash and securities. These hedge funds have heard the rumors and have been watching the market prices of Beta's equity and debt in order to gauge Beta's prospects. They begin to shift their cash and securities to better-capitalized prime brokers or, safer yet, to custodian banks. Beta's franchise value is thus rapidly eroding; its prospects for a merger rescue or for raising additional equity capital diminish accordingly. Potential providers of new equity capital question whether their capital infusions would do much more than improve the position of Beta's creditors. In the short run, a departure of prime-brokerage clients is also playing havoc with Beta's cash liquidity, because Beta has been financing its own business in part with the cash and securities left with it by these hedge funds. As they leave, Beta's cash flexibility declines to alarming levels.

Although Beta's short-term secured creditors hold Beta's securities as collateral against default losses, at this point they see no good reason to renew their loans to Beta. Potentially, they could get caught up in the administrative mess that would accompany Beta's default. Moreover, even though the amount of securities that they hold as collateral includes a "haircut"-a buffer for unexpected reductions in the market value of the collateral-there remains the risk that they could not sell the collateral at a high enough price to cover their loans. Most of these creditors fail to renew their loans to Beta. A large fraction of these short-term secured loans are in the form of repurchase agreements, or "repos." The majority of these have a term of one day. Thus, on short notice, Beta must find significant new financing, or conduct costly fire sales of its securities.

Beta's liquidity position is now grave. Beta's treasury department is scrambling to maintain positive cash balances in its clearing accounts. In the normal course of business, Beta's clearing bank would allow Beta and other dealers the flexibility of daylight overdrafts. A clearing bank routinely holds the dealer's securities in amounts sufficient to offset potential cash shortfalls. Today, however, Beta receives word that its clearing bank has exercised its right to stop processing Beta's cash transactions, given the exposure of the clearing bank to Beta's overall position. This is the last straw. Unable to execute its trades, Beta declares bankruptcy.

Beta Bank is a fictional composite. In what follows, my goal is to establish a factual foundation for the key elements of this story. In addition to providing institutional and conceptual frameworks, I will propose revisions to regulations and market infrastructure.

Economic Principles

The basic economic principles at play in the failure of a large dealer bank are not so different from those of a garden-variety run on a typical retail bank, but the institutional mechanisms and the systemic destructiveness are rather different.

A conventional analysis of the stability of a bank, along the lines of Diamond and Dybvig (1983), conceptualizes the bank as an investor in illiquid loans. Financing the loans with short-term deposits makes sense if the bank is a superior intermediator between depositors, who are usually interested in short-term liquidity, and borrowers, who seek project financing. The equity owners of the bank benefit, to a point, from leverage. Occasionally, perhaps from an unexpected surge in the liquidity demands of depositors or from a shock to the ability of borrowers to repay their loans, depositors may become concerned over the bank's solvency. If the concern is sufficiently severe, the anticipation by depositors of a run is self-fulfilling.

The standard regulatory tools for treating the social costs of bank failures are the following: supervision and risk-based capital requirements, which reduce the chance of a solvency threatening loss of capital; deposit...