Bank Resolution and Too Big To Fail Is Bail-in the best answer?

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					 Bank Resolution and Too Big To Fail
 Is Bail-in the best answer?




 October 2010


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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



                                                           Slide 2
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?

                                                                             Slide 3
Some Resolution Options

      Bankruptcy – liquidate assets and distribute proceeds




                                                                       Old
     Bail-out – use tax dollars / guarantees to protect [some]
  investors


      Dodd-Frank – FDIC seizure + “orderly liquidation process”


      Narrow Banking / Atomized Banking – “small enough to fail”?




                                                                       New
      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


                                                                             Slide 4
“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
                                                                    vs.
                                                         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
                                                                               Slide 5
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
      franchise)
   – 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
      decisions)
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


                                                                                        Slide 6
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

                                                                                           Slide 7
Growing interest and support
Political/ regulatory:
                                                          Bank Associations:
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)
         Barclays

                                                                                                 Slide 8
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

                                                                               Slide 9

				
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