How To Succeed At Failing

In response to my earlier post, commenter Reido writes:

A resolution authority sounds like a very prudent idea, but the high interconnectedness of financial institutions makes me skeptical of its ultimate effectiveness. An institution's creditors are readily identifiable, but the complicated network of dependencies that result from CDSs and CDOs much less so. One default's effect can bounce up and down and all around the system via the holders of relevant CDS. Foreclosures and/or risk of foreclosures of a clump of properties can devalue the relevant CDO regardless of how otherwise isolated the owner is from the underlying market. Given an entity like Lehman Brothers, what failure resolution plan would have worked?

It is incredibly difficult to envision. But let's give it some thought.

First, the challenge in creating such plans is why the burden will be on the firms themselves to create them. If they can't explain how their failure would work without creating a dangerous domino effect, then that raises the question of what should happen. Should the firm be broken up? Should it be forbidden from participating in certain markets? I'm not sure, but a firm should not be able to take an entire economy down with it if it fails.

Still, I am somewhat optimistic that such failures could take place without wrecking the market. In the case of Lehman -- it did fail. It was messy, but life went on. So the question, I think, is not how to make it painless: any failure necessarily involves some pain for the economy. But there's a difference between it being unpleasant and resulting in a financial crisis.

Some of the firm's counterparties, creditors, etc. will certainly lose money. But the losses those other firms face should not prevent them from continuing to function and cause their demise as well. That's why a part of resolution plans would likely include what capital would be prudent for firms to hold onto in case of their failure, to insure some minimum threshold of their obligations would be covered. That would vary from firm to firm. One of Lehman's (and other banks') big issues was its leverage level. If it had more capital to cover more of its obligations, its failure would not have posed as great a threat.

Another example of something that could help would be more diversity in creditors. Maybe there should also be concentration limits on counterparty firms. Certainly, there are many aspects of a firm's business to look at, but it isn't really about isolation. Financial firms will always be connected. The trick is creating a situation where, if those connections are suddenly severed, those connected firms don't also fail.