A proposal for efficiently resolving out-of-the money swap positions at large insolvent banks
Paper by George G. Kaufman, Professor of Finance and Economics, Loyola University Chicago
Recent evidence suggests that bank regulators in the US 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. This paper looks at this situation from a new angle.
This paper proposes a third option that keeps the benefits of both options but eliminates the undesirable costs. The proposed simulated closeout 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 by charging them the same prorata losses as other general creditors and thus maintaining discipline on banks by large and sophisticated creditors and satisfying least-cost resolution.