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economies of scale

The contribution of our paper is to characterize the main trade-offs between MPOE and SPOE resolution in the context of a simple model of global banks and national regulators. We first show that bank resolution that is exclusively conducted through an intervention on the liability side—by imposing losses on equity or writing down debt issued by the financial institution’s holding company—has to go hand in hand with a regulatory requirement for holding companies to issue a sufficient amount of equity or long-term debt so as to guarantee sufficient loss-absorbing capacity. In our model, asymmetric information about long-term cash flows makes equity and long-term debt expensive relative to short-term debt. Therefore, absent a requirement to issue long-term loss-absorbing securities, financial institutions may choose to rely excessively on short-term debt as a source of funding. Because runnable short-term debt cannot credibly be written down, an orderly resolution then becomes impossible. Like in the fall of 2008, this would leave a disorderly liquidation via a bank run or a tax-funded bailout as the only remaining options.

We then show that, for global financial institutions that operate in multiple jurisdictions, SPOE is the efficient resolution mechanism in a benchmark setting in which regulators maximize joint surplus and can commit to cooperating in the middle of a crisis, thereby emulating the actions of a benevolent supranational regulator. Because SPOE resolution allows regulators to transfer resources between operating subsidiaries in different jurisdictions, a successful SPOE resolution regime can be achieved with a lower amount of required loss-absorbing capital than would be possible under separate national MPOE resolution schemes. As a result, for the same level of risk acceptable to regulators, SPOE resolution allows global financial institutions to provide more socially beneficial banking services than would be possible under MPOE resolution. Moreover, because the bank is resolved as a whole, efficiency gains from global banking are preserved.