A Proposal for Efficiently Resolving Out-of-The-Money Swap Positions at Large Insolvent Banks

27 Pages Posted: 14 Apr 2003

Date Written: January 6, 2003

Abstract

Recent evidence suggests that bank regulators 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. Terminating contracts abruptly may result in large fire-sale losses and ignite defaults in other swap contracts. Transferring the contracts both is costly to the FDIC and protects the counterparties, who would otherwise be at-risk and monitor their banks. This paper proposes a third option that keeps the benefits of both options but eliminates the undesirable costs. It 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, thus maintaining discipline on banks by large and sophisticated creditors.

Suggested Citation

Kaufman, George G., A Proposal for Efficiently Resolving Out-of-The-Money Swap Positions at Large Insolvent Banks (January 6, 2003). Available at SSRN: https://ssrn.com/abstract=378840 or http://dx.doi.org/10.2139/ssrn.378840

George G. Kaufman (Contact Author)

Loyola University Chicago ( email )

820 North Michigan Avenue
School of Business
Chicago, IL 60611
United States
312-915-7075 (Phone)
312-915-8508 (Fax)

HOME PAGE: http://www.luc.edu/faculty/gkaufma/

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