Resolving failed banks

In market economies free entry and exit sorts out winners and losers and thus minimises political considerations and maximises economic ones in how resources are allocated. This process and the company bankruptcy laws that underlie it make an enormous contribution to the efficiency and faster growth of market economies over more heavily regulated or state-directed ones.

Company bankruptcy normally takes the form of shutting the firm down, locking its doors, and selling off anything of value (normally taking a few years) and distributing the proceeds to the creditors in the order of the legal priority of their claims. The firm’s creditors thus absorb losses in excess of capital. The value of the firm’s assets is whatever the receiver can sell them for. It is a transparent and objective, but slow process. In some instances, however, the highest value for a failing company is obtained by selling it whole or in part to another company that is able to run it more efficiently and that is freed of some of the failing company’s debts. Shutting down operations for the few months that might be needed to find new owners is generally not particularly harmful.

These procedures would not work for a bank. If a bank’s depositors, normally its primary creditors, fear that it may not be able to honour its obligations, they will move their funds to other, safer banks. Closing and liquidating a bank as a way to repay creditors would seriously impede the payment system and could bankrupt many depositors even if they ultimately received all of their money back. For this reason many countries have introduced deposit insurance to protect depositors from loss in the event that their bank fails. In principle deposit insurance should be limited to small to modest deposits so that the larger depositors will pay attention to the condition of their bank. Such market scrutiny of a bank’s capital, liquidity and risk taking forces banks to operate prudently in order to attract and keep deposits.

For many years the US and most of the rest of the world have gone in opposite directions with regard to the treatment of banks that became insolvent. In the US the Federal Deposit Insurance Corporation (FDIC) takes over insolvent or critically undercapitalised banks and arranges for another bank to acquire their good assets and to assume their deposit liabilities. If the good assets are not of sufficient value to cover the assumed deposit liabilities, the FDIC will pay the acquiring bank enough to cover the difference up to its insurance liability for the insured deposits.

Such purchase and assumption transactions are generally arranged over a weekend so that the depositors are never without access to their funds. By intervening early when a bank begins to make losses, the FDIC has generally been able to protect all depositors, both insured and uninsured, from losses. On the few occasions when a bank’s losses exceeded what could be absorbed by the FDIC’s insurance commitment, it imposed the excess loss on bond holders and uninsured depositors via haircuts.

The goal in all cases of large bank failures is to enable the bank or its successor to continue operating in a recapitalised condition. The legal and practical challenge is to provide the regulator – in the American case, the FDIC – with the legal authority to take a bank from its owners on the basis of a judgmental evaluation of the value of its assets relative to its liabilities. Unlike normal company bankruptcy, where the value of assets is objectively determined by the price they receive when sold in the market (though almost always many months later), the value of the assets of a bank must be estimated at the time of take over and is by its nature uncertain: what value will ultimately be realised on overdue loans?

Moreover the open bank value of a bank is almost always greater than the value from liquidating a closed bank (the FDIC is required to resolve a bank in the least costly way to the fund). Faced with these challenges European and other regulators have almost always chosen to bail out insolvent or undercapitalised banks, ie to inject tax payer money into the banks to cover their losses.

This has begun to change in Europe with the nationalisation of Northern Rock in the UK in February 2008. The bank was nationalised, the only legal tool available in the UK for taking an insolvent bank from its owners without closing it, when the Bank of England refused to lend to it on the grounds, I assume, that it had negative net worth and efforts to sell it fell through. From the early days of central banks, they have been mandated to lend, as the lender of last resort, to illiquid but solvent banks and not to lend to insolvent banks. As a result, Northern Rock was unable to honour its obligations as they fell due; they could not pay out to depositors and other short-term interbank lenders wishing to withdraw. When several large Irish banks defaulted later the same year, the EU insisted that the Irish authorities bail out everyone but the owners as a condition of EU/IMF financial support.

The failures of Iceland’s largest banks shortly after the Lehman Brothers collapse in September 2008 tread new ground and initiated new legal challenges and issues. But it is the division of Cyprus’s two largest banks into a good bank and a bad bank and the recapitalisation of the good bank by bailing in bond holders and uninsured depositors (ie writing off bond holder claims and applying large haircuts to uninsured depositors) that represents the most dramatic change in approach. No taxpayers’ money was used to recapitalise the surviving bank. The goal of bailing in creditors is to replicate what they would have received from a normal corporate bankruptcy and liquidation without having to close the bank.

These experiences are explored in the following articles by Gary Gegenheimer (Cyprus), Birgir Tjörvi Pétursson (Iceland), Tim Ridley (Why Cayman is not Cyprus) and Louise Berrett (How to liquidate banks and the rise of regulatory protectionism).

In a speech in London on 25 April, IMF First Deputy Managing Director David Lipton stated that the IMF supports a market-based bail-in approach to bank resolution as is being considered in the European Union Directive on Bank Recovery and Resolution. “This approach places the primary burden on each institution and its creditors rather than its country, and could defuse some of the political tension on this subject.” An article by Miranda Xafa explores the discussion by the EU over how deep and with what priority creditor haircuts should be applied (European Union Directive on Bank Recovery and Resolution).

“Bailing out” a bank refers to covering its losses with someone else’s money (tax payers somewhere) and “bailing in” a bank’s creditors refers to covering its losses, after its capital is used up, with bondholders and uninsured depositors’ money via “haircuts” – writing off part of their value. Both allow a bank or its main activities to continue with little to no interruption. The former “socialises” losses while leaving any gains from successful bets to the private owners and creates a serious moral hazard leading to excessive risk taking by banks unless regulations are successful in preventing it. The latter (bailing in) makes depositors financially responsible for excessive bank losses and restores the market’s discipline of bank risk taking.

The Cyprus approach to bailing in is very promising as market discipline is generally more effective than regulatory discipline, but the dramatic change in the implicit rules in Cyprus was very large and abrupt. A clear and careful transition to greater market regulation, by putting uninsured depositors at risk, is needed to give banks time to adjust their business models and asset portfolios in ways that will give confidence to depositors that their bank is safe. Nonetheless, no deposit runs have been observed elsewhere in Europe following the resolutions adopted in Cyprus.

The evolving approaches to resolving failing banks so that none is too big to fail will hopefully strengthen market discipline of bank risk taking, but interesting proposals and initiatives to better protect depositors and taxpayers by directly regulating the activities of depository-payment system institutions should also be considered. These include proposals to impose much higher capital requirements on very large banks (see the “Terminating Bailouts for Taxpayer Fairness Act” introduced to the US Senate on 24 April, 2013 by Democrat Sherrod Brown and Republican David Vitter), or to impose greater limitations than now on what depository institutions can do with the funds deposited with, or created by, them.

Several approaches are discussed in the following articles. Dalibor Rohac presents intriguing evidence from the area of traffic regulation that fewer rules can be better rules. Forest Capie and Geoffrey Wood discuss new/old approaches to achieving bank capital adequacy that reflect the moral hazard of bailouts and the market discipline of bail ins discussed above. Michael Kumhof summarises a study with Jaromir Benes at the IMF of the more radical “Chicago Plan” of 100 per cent backing of bank deposits with central bank currency and/or deposits with the central bank. Under such a plan deposit insurance would not be needed, as deposits would always be one hundred per cent safe and liquid. For the same reason prudent levels of capital could be very low.



FDIC seal by Matthew Bisanz