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incentive compatible resolution: A hybrid approach

A key condition for the proposed G-SIB resolution mechanisms to work is that the bank holding company must have sufficient total loss-absorbing capital (TLAC)—in the form of equity or subordinated long-term debt—to absorb losses of its operating subsidiaries and ensure the safety of their short-term liabilities. Then, even if the operating subsidiary suffers heavy losses, the holding company has sufficient capital to plug the hole. This prevents a creditor run on the operating subsidiaries, which can continue to operate as usual during resolution.

Because the proposed resolution mechanisms rely on sufficient loss-absorbing capital, the first key question in assessing G-SIB resolution is whether the controlling shareholders of the bank holding company will, in fact, find it in their interest to issue a sufficient amount of TLAC. As we show in Proposition 1, this is generally not the case. The reason is that asymmetric information about long-term cash flows make equity and long-term debt expensive relative to short-term debt. If the asymmetric information discount is large enough, the shareholders of the holding company find it privately optimal to rely on risky short-term debt financing, even at the risk of a default and ensuing creditor run at date |$1$|⁠. Therefore, a minimum TLAC requirement is an essential complement to the proposed G-SIB resolution mechanisms. Proposition 1 summarizes this result. Appendix A provides the detailed derivation of the bank’s financing choices and the resultant pooling equilibrium.