Bank Resolution Concepts, Tradeoffs, and Changes in Practices

During the recent crisis, we observed the failure or near failure of some of the world's largest financial institutions, requiring the regulators to intervene to resolve these institutions. Banks and financial intermediaries perform important functions such as channeling resources from savers to productive projects and providing important payment services to their customers through their money-like liabilities. Hence, their failure can result in costs for the economy and an efficient resolution mechanism can mitigate such costs. In this paper, we provide a discussion of the costs associated with bank failures, the methods used by regulators to resolve banks, and the costs of different methods. Furthermore, we provide a simple framework to analyze the optimality of resolution methods. We show that while private resolution methods, such as sale to a healthy bank, are preferred options, they may not be feasible during systemic crises. Hence, regulators need to employ a state-contingent resolution mechanism. Resolution during a systemic crisis entails tradeoffs between disruptions arising from a disorderly liquidation and potential moral hazard resulting from the use of public funds