Recent evidence suggests that bank regulators appear to be able to resolve insolvent large
banks efficiently without either protecting uninsured deposits through invoking “too-big-tofail”
or causing serious harm to other banks or financial markets. But resolving swap
positions at insolvent banks, particularly a bank’s out-of-the-money positions, has received
less attention. The FDIC can now either repudiate these contracts and treat the in-themoney
counterparties as at-risk general creditors or transfer the contracts to a solvent bank.
Both options have major drawbacks. Terminating contracts abruptly may result in largefire
sale losses and ignite defaults in other swap contracts. Transferring the contracts both
is costly to the FDIC and protects the counterparties, who would otherwise be at-risk and
monitor their banks. This paper proposes a third option that keeps the benefits of both
options but eliminates the undesirable costs. It permits the contracts to be transferred,
thus avoiding the potential for fire-sale losses and adverse spillover, but keeps the insolvent
bank’s in-the-money counterparties at-risk, thus maintaining discipline on banks by large
and sophisticated creditors.