Credible Losers: A Regulatory Design for Prudential Market Discipline

Abstract

A remarkable fact about post-crisis attempts to end the “too-big-to-fail” status of systemically important financial institutions (SIFIs) is how much these efforts depend on the creation of new classes of “loss-absorbing” creditors. If there is one thing SIFIs have never lacked, it is an abundance of creditors that can legally absorb losses in the event of failure. Regulators were unwilling to let losses fall on the trillions of dollars of debt claims held by these creditors during the financial crisis. How, then, is creating a new class of debt supposed to change regulators’ calculus when the next SIFI falters? This article seeks to resolve this apparent paradox by identifying key criteria that must be met for the loss-bearing function of creditor claims on a SIFI to be credible—criteria that had not previously been satisfied but that are arguably met by a proposed new rule requiring certain U.S. SIFIs to issue long-term debt out of their parent holding companies. It further argues that the existence of “credible losers,” among SIFI claimants, not only makes SIFI failure less damaging when it happens, but can also make failure less likely to occur in the first place.

Keywords: banking regulation, financial regulation, sifi, systemic risk, bail out, bail in, tlac, market discipline