CHICAGO – The biggest financial nightmare looming over the world economy is the insolvency of a large international bank. Be it because of a sovereign default or because of large losses accumulated under complacent accounting rules, the insolvency of a large bank (particularly a European bank) is far from a remote possibility. Even if it were a remote possibility, the 2008 financial crisis has taught us that rare events occur.
What makes this possibility the financial nightmare of choice, worse than the collapse of Lehman Brothers in 2008, is the fear that many sovereign states have already shot all their bullets and would thus be powerless to intervene. Credit default swaps (CDS) of major southern European banks trade slightly lower than the CDS of their sovereign states, indicating that the market does not perceive the latter as able to support the former.
Unfortunately, almost two years after Lehman’s collapse, little has been done to address this risk. The United States Congress is about to finalize a bill that will grant resolution authority over major US financial institutions to a newly formed systemic council. The procedures to trigger this intervention, however, are complex and the funding is sufficiently opaque that the bill will not eliminate collateral damage from a large bank failure even for US institutions, let alone for international ones, whose unwinding would require coordination by several states, with varying degree of solvency.
To minimize the risk of an unruly collapse, it is necessary to approve an international resolution mechanism with authority over all major international financial institutions. The goal would not be to rescue banks and their creditors, but to minimize the disruption that an uncontrolled default might cause.