Ending Too Big To Fail: What Is The Proper Role For Capital And Liquidity

Baumann, Chakravorti, and Shaaya identify and summarize the recent academic and industry literature on the benefits of large banks from the perspective of economies of scale and scope along with the benefits of a large, diverse set of products and services provided by a large bank. Second, they explore how large banks are able to leverage their broad customer bases to increase the pace and spread of innovations. Third, they discuss how risk diversification is a key benefit of large banks that augments their resiliency and stability. Finally, they examine the policy implications of our findings.

Chakravorti studies systemic risk in multilateral net settlement systems is investigated using a four-period model. The model focuses on the tradeoff between systemic risk and the cost of interbank transfers along with the importance of the overnight money markets that were a key factor in the most recent financial crisis. Banks optimize their reserve holdings at the central bank, the settlement medium, based on a future random liquidity shock and payment system parameters such as total asset and collateral requirements, and net debt caps. The model’s results are as follows. The model determines the maximum number of bank defaults that can be sustained without a stoppage in the clearance and settlement process. An interbank funds market increases the efficiency of the payment system. The payment system operator can reduce systemic risk by imposing asset and collateral requirements, and debit caps. The central bank can provide sufficient liquidity to prevent a systemic collapse but may face high costs.

The Mexican securities clearance and settlement system is ahead of many markets in terms of having one of the shortest settlement periods. However, cross-border transactions—such as those involving American Depositary Receipts—have tended to be associated with a greater number of settlement fails than purely domestic transactions because the U.S. and other foreign markets have longer settlement periods. Chakravorti investigates reforms to the Mexican securities clearance and settlement system that are aimed at improving liquidity and efficiency while maintaining safety and reducing both general and cross-border settlement fails. These reforms include penalties for late settlement and the establishment of an electronic lending facility. In addition, a proposed clearinghouse would bilaterally net securities transactions that involve the same type of security.