A working paper from the Federal Reserve of Richmon considers that a large financial institution is “resolvable” if policymakers would allow it to go through unassisted bankruptcy in the event of failure. The choice between bankruptcy or bailout trades off the higher loss imposed on the economy in a potentially disruptive resolution against the incentive for excessive risk-taking created by an assisted resolution or a bailout.
The resolution plans (living wills) of large financial institutions contain information needed to evaluate this trade-off. In this paper, researchers propose a tool to complement the living will review process: an impact score that compares expected losses in the economy stemming from a resolution in bankruptcy with those expected under an assisted resolution or a bailout, based solely on objective characteristics of a bank holding company. Researchers provide a framework that allows discussion of the data needed and the concepts that underlie the construction of such a score. Importantly, the same firm characteristics may be ascribed different impacts under different resolution methods or crisis scenarios, and these impacts can depend on policymakers’ assessments.
Researchers say that a firm’s structure is acceptable if its impact score under bankruptcy is lower than that of any other resolution method. They study the current score used to designate firms as GSIBs and propose a modified version that we view as a starting point for an impact score.