For once Darling has had a good idea

A LIVING will sounds like an oxymoron – dead wills are not exactly two a penny – but it merely refers to a set of instructions, known to all during the deceased’s lifetime, for dealing with his assets once he passes away. In the same vein, one proposal to be included in tomorrow’s White Paper on bank reform will be that large financial institutions will have to detail how they could be wound down in a controlled and organised manner in the event of their death.

Alistair Darling’s paper is likely to contain many nasty surprises. There will be plenty of destructive proposals. But the living will concept (endorsed ages ago by Mervyn King) is a good idea. A bank’s management should have to lay out in advance a “resolution plan” explaining how their firm can easily and cheaply be dismantled – just in case disaster strikes.

Giant financial institutions are like a pack of cards; they can easily be taken down from the top, but if you remove a card from the bottom the entire thing collapses. It also makes sense for large firms to be structured in such a way that any bits deemed systemic can be rescued quickly while the remainder can be allowed to go bust after a painless break-up. One of the advantages to this approach is that it avoids an irrational compulsory separation between retail and investment banks, or arbitrary limits on firm sizes. It also reduces moral hazard: at the moment, if you are a bondholder in a large institution, you know you will be safe because the entirety of the institution will have to be rescued, rather than just parts of it. The Treasury is keen on moving most credit default swaps (CDSs) onto exchanges, which is another precondition to an orderly wind-down of bust institutions, as is the need for total clarity about all major counter-party risk. The (flawed) rationale for nationalising AIG was that nobody knew which institutions were exposed to it; uncertainty about Lehman’s counterparties was also why the (correct) decision to allow it to go bust unfortunately caused so much panic.

Had such a plan been in place in the US, AIG might have been allowed to go bust in a smooth, gentle manner and without taking down the system with it. In Britain, HBOS’s commercial banking operations could have been allowed to go bust, while the deposits and branches could have been preserved and sold to somebody else. It should certainly have been possible to wind-down and liquidate most of RBS, even if depositors were protected.

Bottom line: anything that makes it easier to allow large banks to go bust, and which reduces the need for bail-outs, is to be welcome.

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