British and US banking regulators proposed on Monday a joint strategy to ensure that the bankruptcy of big banks won’t spark a chain reaction of contagion throughout markets.

The two bodies, acting on behalf of the two largest financial centres in the world, stressed that under the proposals, shareholders and not taxpayers would bear the full costs, and top managers would be sacked.

ADVERTISEMENT

At the Bank of England, the deputy governor for financial stability Paul Tucker said: “The ‘too big to fail’ problem simply must be cured. We believe it can be and that this joint paper provides evidence of the serious progress that is being made.”

The British and US authorities said in a joint statement that the financial crisis had “driven home the importance of an orderly resolution process for globally active, systemically important, financial institutions” which have foundered.

They said that their solutions, which would target the parent of any finance house in trouble, “have been designed to enable large and complex cross-border firms to be resolved without threatening financial stability and without putting public funds at risk.”

They said they had borne in mind work by the G20-backed Financial Stability Board on principles for dealing with failed financial institutions.

There has been widespread criticism of the way in which Lehman Brothers investment bank was closed down, triggering a massive crisis of confidence, and that in the disruption that followed some shareholders did not carry the full brunt of the costs and some managers held on to their boardroom jobs.

ADVERTISEMENT

In the United States and in Europe, governments had to use taxpayers’ funds to provide guarantees or new capital to financial institutions in trouble. Creditors lost money but most depositors were protected.

The objective is to minimise the dangers of so-called “systemic risk”, when a sudden loss of confidence threatens to trigger chaos throughout the financial system as nearly occurred in 2007.

The strategy by the Bank of England and the US Federal Deposit Insurance Corporation is a response to the traumas and lessons of the financial crisis which followed.

ADVERTISEMENT

The statement said that the British part of the strategy was intended to fit with the powers provided by the UK Banking Act of 2009 “and in anticipation of the further powers that will be provided by the European Union Recovery and Resolution Directive.”

Britain, a member of the European Union but not of the eurozone, is campaigning hard on another front which has a bearing on bank resolution: this is progress towards an EU banking union, built initially around the 17 eurozone members with banking supervision vested in the European Central Bank.

ADVERTISEMENT

Britain is concerned that this could become a back door way for eurozone and EU authorities to interfere in regulation of the financial sector in Britain in a way which would damage British interests.

The statement said that the proposals were based on a “top-down” strategy for dealing with financial firms in severe difficulty, whereby a single authority would apply its powers “to the top of a financial group, that is, at the parent company level” and across borders.

In the United States the measures would work in the context of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

ADVERTISEMENT

“Such a strategy would apply a single receivership at the top-tier holding company, assign losses to shareholders and unsecured creditors of the holding company, and transfer sound operating subsidiaries to a new solvent entity or entities,” said the statement.

Both the US and British approaches would “ensure continuity of all critical services performed by the operating firm(s), thereby reducing risks to financial stability.”

The joint statement said: “The unsecured debt holders can expect that their claims would be written down to reflect any losses that shareholders cannot cover, with some converted partly into equity in order to provide sufficient capital.”

Subsidiaries which were viable would be kept open and operating, “thereby limiting contagion effects and crossborder complications.”

ADVERTISEMENT

The statement also made clear that action to deal with financial firms in trouble “would be accompanied by the replacement of culpable senior management.”

The full document is available at:http://www.bankofengland.co.uk/publications/Documents/news/2012/nr156.pdf.