Managing Financial Failure in an Evolving Economic and Financial Environment

Increased international linkages within and across institutions may make crises more broad-ranging and complicated to deal with. This underscores the importance of policymakers continuing to ensure that national legal, regulatory, and supervisory arrangements evolve to cope with the increasingly globalized nature of institutions. The emergence of large and complex financial institutions (LCFIs) poses significant challenges for managing and resolving financial failures. The complexity of these institutions makes effective supervisory oversight harder. The vulnerability of the financial system to the complexity that they entail is illustrated by the unfolding of the subprime crisis. Weaknesses associated with the manner in which the “originate to distribute” model has been implemented gave rise to serious disruptions. To engage in off-balance sheet maturity transformation, a number of financial institutions sponsored the establishment of separate legal entities (“conduits” and structured investment vehicles or SIVs). These entities funded purchases of asset backed securities (ABS) and corporate bonds by issuing shorter-term commercial paper and medium-term notes (MTN). When liquidity dried up in the markets in which the entities funded themselves, the sponsoring institutions did not abandon them. Instead they provided funding even though the conduits are separate legal entities and could have been allowed to fail. Corporate form failed to follow corporate function.