Liquidity in Resolution – A Transatlantic Perspective 

By Sebastian Grund

ABSTRACT

This Article argues that the current frameworks for the orderly resolution of large financial institutions suffer from a liquidity problem. The main reason for this predicament is that post-crisis reforms on both shores of the Atlantic enjoined central banks from providing liquidity to financial firms during and immediately after resolution. By creating a bright line rule prohibiting lender-of-last-resort (LOLR) operations once a firm enters resolution proceedings, there is a risk that firms will no longer be able to roll over short-term debt, thereby increasing risks to financial stability. As this Article shows, however, there are important differences between the United States (U.S.) and Europe. While the U.S. Congress at least sought to minimize liquidity gaps in resolution by throwing the fiscal firepower of the United States in the ring, European lawmakers failed to agree on a genuine, common backstop for the resolution of significant credit institutions, leaving only a small window for national solutions. To meet the core objectives of resolution, which include allocating losses to equity and long-term debt holders rather than to taxpayers, the central bank should be given a limited LOLR role to shore up the resolved firm’s funding. This LOLR function ought to be guaranteed by the fiscal authority, subjected to ex-ante volume limits, and limited to short-term credit. Moreover, to further mitigate latent moral hazard and to create a counterweight to the extended LOLR function, the Article advocates for higher capital requirements.