Bank Resolution and Too Big To Fail
Is Bail-in the best answer?
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The next big thing: resolution reform
Addressing the problem of „too big to fail‟ is therefore
the next central step in the reform program . . .
Effective regimes must enable the authorities to
resolve financial crises without systemic disruptions
and without taxpayer losses. . .
Mario Draghi (Head of the FSB)
Financial Times, 9/16/2010
Important features of a resolution framework:
Two main approaches to reform:
1. More capital / regulation: “make failure impossible”
2. Create a viable bank resolution process: “make failure manageable”
Some key questions:
– Can we make failure impossible?
– What is critical to reduce risk of contagion / systemic collapse?
– Is the goal “strict justice” or an “economic efficiency”?
– Should governments supply risk capital (or protect certain investors)?
– Can we address moral hazard?
– How to deal with the international dimension?
– How will participants react to the solution? Is the solution stable?
Some Resolution Options
Bankruptcy – liquidate assets and distribute proceeds
Bail-out – use tax dollars / guarantees to protect [some]
Dodd-Frank – FDIC seizure + “orderly liquidation process”
Narrow Banking / Atomized Banking – “small enough to fail”?
Resolution Fund – create a pool to “socialize” loss
Co-Cos / BCBS 174 – helpful . . . but enough to turn the tide?
Bail-in – fast track recapitalization + supporting measures
“Bail-in” - Lehman example
1) Write-down assets (~ $25 bn rough estimate)
2) Recapitalize: Old Balance Sheet New Balance Sheet
$25bn equity warrants
$25bn preferred & sub debt new equity
$120bn senior debt 15% equity (85% unchanged)
No impact on customers, repo, swaps or insured deposits
3) Top Management is removed Investor losses:
4) Liquidity plan established Bail-in: ~ $25bn
Liquidation : ~ $150bn
“New Lehman”- best capitalized bank in the US (current market value)
– Customer activities continue as normal – going concern
– No government capital at risk – not a bail-out
– System under much less stress
Bail-in – some general principles
1) Write-down: Best estimate - credible to market, and fast (not perfect)
2) Recapitalize: restore capital (post-write-down) to a very strong position
– Haircut / convert unsecured capital (starting with equity up to senior unsecured
debt, as needed to create sufficient equity, in order of creditor priority)
– No haircuts to “customer activities” (e.g. transaction payments, settlements,
prime banking, normal derivatives – activities that are crucial for a banking
– No haircuts to protected liability classes (normal repo, insured deposits)
– Protocol of how investors are treated in recap should have clear terms – not
“constructive ambiguity”. Should include: strict priority; fairness within each
class and across borders; and transparency (so investors can make good
3) Management: remove CEO, maybe others - but need to keep some key leaders
4) Liquidity: need a clear, convincing plan (e.g. consortium funding “LTCM” model,
possibly central bank support). Super-senior “DIP” financing could be a key tool
Other building blocks
Best legal foundation is likely a hybrid, using both statutory & contractual elements
Confer key powers and responsibilities on home regulator
Augment with contractual support (e.g. debt issued outside home country)
Over time, could be supported by mutual recognition and other agreements
Allows for a “building block” approach, which could be adopted nation by nation, rather than
requiring a difficult initial multi-lateral agreement.
Legal process must be convincing & quick (e.g. a weekend) to ensure confidence.
Process could allow for some ex post rebalancing of claims among classes, but overall
recapitalization must be convincing to the market.
Living Wills could be an extremely helpful preparatory tool – to ensure speed and efficacy
Trigger for bail-in should be very late - “non-viability” finding by lead regulator
Equivalent to regulatory seizure – other normal private options exhausted
Must precede legal bankruptcy to avoid acceleration of contracts /debt.
Swap acceleration must be avoided; ISDA protocol process likely best route
International „ring-fencing“ must be avoided to keep franchise alive
Bail-in can provide strong incentives for cooperation, even in crisis. It creates capital and
liquidity – the 2 elements that a stressed host regulator needs most
Growing interest and support
We called upon the FSB to . . develop
concrete policy to . . resolve systemically
important financial institutions by the Seoul
Summit. This should include . . contingent
capital, bail-in options . .
(Toronto G-20 Communiqué)
Effective regimes . . should include powers
that facilitate “going concern” capital and Recent Press
liability restructuring. . .
Statutory powers enabling the resolution “probably the best idea out there right now”
authority to bail-in senior debt holders would (Financial Times, July)
expand the options for going concern
resolution . . (Mario Draghi, Head of FSB)
“The bail-in idea deserves a strong push”
(Breaking Views / NY Times, September
Credit Research: “a particularly intriguing idea kicking
around Basel is the concept of a "bail-in"
JP Morgan, CreditSights, (Wall St Journal Editorial, September)
Goals of a Bail-in regime
Avoid government-backed bail-outs
– Creates access to huge pool of potential equity in a crisis (2x – 5x larger)
– Extra capital cushion can absorb losses much greater than 2008 crisis
– Effectively forms a deep “resolution fund” funded by private capital
Major reduction in systemic risk
– Dramatically reduces cost of bank failure and contagion
– Protects depositors, and key customer activities – should reduce runs
– Could help solve the vexing problem of cross border resolution
Better for the real economy - and likely a more durable reform
– A more efficient, market-oriented alternative
– Better market signals will help discipline management & inform regulators