Collateral and the Role of International Merchant Banks in the Spread of Aggregate Risks

Non-financial corporations (NFCs) can use a whole range of instruments to collateralise bank loans. A form of systemic risk can arise in this context when the collateral consists of debt instruments issued by international merchant banks (outside collateral) and the assets of those banks simultaneously consist largely of shareholdings in the same set of NFCs. This situation, which is common in the Anglo-Saxon banking world, gives rise to a range of idiosyncratic risks for all the parties involved and also generates aggregate risk. In this article, we investigate the situation where an aggregate economic shock gives rise to increased NFC insolvency rates and where foreclosure on outside collateral by NFC creditors combined with a reduction in the value of shareholdings leads to impairment of merchant bank assets. Contagion risk arises and the sector becomes fragile (has a short distance to default) regardless of competition. This situation creates a high risk of official guarantees being issued for the liabilities of merchant banks. An alternative without the need for public sector involvement is to introduce simple bail-in principles for systemically important merchant banks by replacing debt instruments with contingent convertible debt. This approach is consistent with new regulatory tools requiring banks to hold, in addition to capital, types of liabilities that can be converted into capital when resolution plans are activated. The tools in question are MREL in the EU (defined in the Bank Recovery and Resolution Directive, BRRD) and TLAC in the USA. These regulations may also be useful for containing systemic risk in open economies serviced by big international banks outside host country regulatory control.