Transcript Managerial Report - Centre for Economic Policy Research

MPI Gemeinschaftsgüter
Martin Hellwig
On the Law and Economics
(and the Politics) of Bank Resolution
Gerzensee
July 3, 2014
Resolution on the Agenda
 2008 experience: No tools for dealing with
systemic banks in crisis
 No tools for reducing systemic fallout of applying
insolvency law
 After Lehman Brothers, all bank creditors were
bailed out
 In „euro crisis“, initially, all creditors were bailed
out – Cyprus and SNS Reaal as paradigm
changers?
 Desire to protect taxpayers
New Legislation
 UK Banking Act 2009: Special Resolution Regime,
run by BoE, requires Treasury approval for any
(exceptional) commitment of taxpayer money
 US Dodd Frank Act 2010: Expanded Resolution
Authority of FDIC, interim funding by Treasury,
ultimate funding by industry levy (DI) and
clawbacks
 German Bank Restructuring Act 2010: Interim
funding by government, ultimate funding by
industry levy (bank restructuring fund) (who does
what is unclear)
EU Banking Recovery and
Resolution Directive
 Special Resolution Authorities in all Member States
 Potential recapitalization before entry into
resolution regime (subject to state aid control)
 Pre-resolution regime („early intervention“) with
supervisor-mandated removal/replacement of
management and/or supervisor-appointed
temporary administrator working with, or replacing
management (conditions vague and unclear)
 Nothing on interim funding
 General principles concerning „bail-in“ tool,
funding from govt. only after this tool has been
used
Euro Area
Single Resolution Mechanism
 Euro area resolution authority (single-entry for
euro area)
 Board (Chair, Vice Chair, four permanent
members, and relevant national authorities), in
charge of adopting a resolution scheme including
relevant resolution tools and any use of the Single
Resolution Fund.
 If the Commission or the Council object to it, the
Board would have to amend the resolution
scheme.
Fundamental Shortcomings
 Multiple-entry resolution for banks with
systemically important operations in different
countries destroys operational procedures (cash
management, IT)
 College of resolution authorities impractical;
 Ditto for procedure under SRM;
 Without prior agreements on loss assignments,
single-entry resolution will not be agreed upon –
ring-fencing in resolution exacerbates the
problems.
Fundamental Shortcomings
 In the EU, interim funding is unclear.
 German Ministry of Finance, January 2011: „If we
were to wind down HRE, there would be a funding
problem and the bank would break down“ Total
liabilities at the time: € 320 bn.
 Projected Restructuring Fund for SRM: € 55 bn.
 In the EU, there is self-deception about ultimate
taxpayer liability/fiscal backstop
 Restructuring levy has limited capacity, even ex
post
 Bail-ins?
Background
 Experiences of the crisis: Lehman Brothers,
Northern Rock, Hypo Real Estate, Fortis
 Cross-border issues: Lehman Brothers, Fortis
 European integration: Commission, ECB and
banking union
 National resistance: Bank Resolution involves
issues of distirbution and power
 Lobbies: Banks and investors like weak
resolution regimes
 Lobbies: Traditional insolvency law specialists
Example: Hypo Real Estate
 October 2008: Hypo Real Estate in trouble, the
government passes a law (FMStG), which allows it to
give banks capital and guarantees. HRE gets
guarantees; in January 2009, the government puts in
new funds and acquires 50% of the equity.
 Spring 2009: „Lex HRE“: The government is given the
powers to „expropriate“ remaining shareholders; in the
summer, a squeeze out takes place (in the shadow of
the Lex HRE, outside shareholders get 1.30 EUR per
share).
 All debt holders are bailed out: Deutsche Bank, Allianz,
Established Churches, Public Radio&TV instititutions,
many municipalities....
The example continued
 March 2009: The ministries (Econ, Finance,
Justice) begin to work
 August 2010: Cabinet decides on a draft Bank
Restructuring Law – „to avoid the HRE experience
ever being repeated“
 December 2010: … Law is passed
 January 2011: „If we were to wind down HRE,
there would be a funding problem and the bank
would break down“ (Comment by finance ministry
on a proposal to wind HRE down in order to reduce
excess capacity in the market)
Why the 2008 bailout?
 Why did shareholders of a bankrupt company
that the government had to bail out get
anything?
 Why were hybrid/junior/senior unsecured
bondholders protected?
 Fear of systemic repercussions
 ... or subsidies to important players?
Notes on German Law
 Unclear procedures and institutional role
assignments
 Primary objective of intervention: creditor
protection! In the past, this has led to insolvencylike procedures, freezing of assets....
 System protection is only subsidiary objective;
Transfer of assets to bridge bank „only if necessary
for avoiding systemic risk“
 „systemic risk“ not defined in terms of systemic
functions (unlike UK) but in terms of importance of
creditors who may need to be protected
Shortcomings
 Creditor protection versus system protection
 A freeze of operations has immediate domino effects
 Rapid liquidation of assets depresses markets and
increases writedown needs at other institutions
 Lack of flexibility
 At the time when dangers are recognized, it is not
yet clear what will be the best way to proceed, how
much of the operation can be or should be saved
 It is also not clear what will be the best mode for
disposing of assets.
 Liability?
Systemic Implications of the
Lehman Insolvency
 Contractual domino effects on Lehman
counterparties, e.g. Reserv Primary Money
Market Fund holding Lehman paper
 Market effects of Lehman unavailability as a
(new) counterparty
 Information contagion effects on markets:
Breakdown of repo markets
 Information contagion effects on banks no
longer expected to be bailed out
 Information contagion on money market funds
Systemic Implications of the
Lehman Insolvency 2
 Defensive reactions of money market funds:
Withdrawals from unaffected banks, e.g.
European banks
 Defensive reactions of banks: Rush for cash,
asset sales
 Asset price declines: due to loss of confidence
and to fire sale effects
 ... feed into further writedowns, causing
further reactions....
 Panic
Lessons learnt (?)
 Banks must be bailed out (lesson learnt by
bankers)
 We need better resolution regimes for banks
or, more generally, systemic financial
institutions
 Reforms so far have mostly been weak and
tentative
 And authorities seem unwilling to apply
them (West LB was not wound down under
the restructuring law)
Contagion mechanisms 1
 Contractual Interconnectedness 1: dominos ex
post: Lehman Brothers – Reserve Primary
 Contractual Interconnectedness 2:
Disappearance of contracting opportunities:
Lehman Brothers as a market maker, money
market fund investors who run, money market
funds that no longer provide wholesale shortterm lending (repo, ABCP)
Contagion mechanisms 2
 Information Contagion: Lehman Brothers not
TBTF has implications for other investment
banks; Reserve Primary breaking the buck
means that other mmmf‘s may not be safe
 Hysteria Contagion? Sunspots and equilibrium
multiplicity, „hypersensitivity“ to information
Contagion mechanisms 3
 Asset price contagion: Fire sales depress asset
prices, which leads to writedowns at banks
with similar positions and possibly further fire
sales by these banks...
 Credit crunch contagion: Defensive strategy of
one institution leads to a reduction in lending,
which forces their borrowers to become
defensive as well
Issues
 Procedural
 When to intervene
 Who
 How to decide which parts of the bank are „good“
and which are „bad“
 How to dispose of the different parts
 Substantive
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
Objectives
Principles
Funding
Legal Issues: Derivatives and Repo
Example: Sweden 1992
Immediate government takeover
Bailout of all debt holders
Full liability of shareholders
New management with new careers to be
made
 Full transparency about losses
 Separation of good and bad banks under
control of government-installed managers
 Adjustment of market structure
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The UK Approach
 Banking Act 2009 creates a Special Resolution
Regime for Banks
 Objective: System Protection (defined in functional
terms) as well as Creditor Protection




FSA pulls the trigger, BoE takes over
… with a great deal of discretion
… but a clear assignment of responsibility
... and there is a fiscal backstop
Discretion of BoE
 Possible Choices of the BoE:
 Immediate sale
 Transfer to a BoE owned bridge bank
 Temporary public ownerhips: transfer of shares to
Treasury in return for funds (Treasury approval,
takeover)
 Restructuring: Bank insolvency procedure, bank
administrative procedure
 Separation of assets, on particular with a view to
protecting markets (netting in derivatives markets)
BRRD procedure

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Supervisor pulls the trigger
(Can try early intervention before)
Resolution authority takes over
Objective System protection
Has wide discretion:
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Sale of business
Bridge institution
Asset separation
Bail-in (only if there is a serious prospect of
recovery)
BRRD procedure 2
 Valuation at time of resolution
 Temporary, to be followed by ex post as soon as possible
 Provides the basis for bail-in
 Assignment of liability (writedowns or conversions)
in the order of the hierarchy of claims under
insolvency law
 „no creditor worse off principle“
Concerns about valuation
 Valuation of assets before resolution is problematic
 In practice, the bank‘s problems are partly due to
the fact that asset values are unclear.
 Examples: MBS, Spanish real-estate loans
 The BRRD‘s requirement is impractical and likely to
give rise to legal disputes
 Example: In 1990, estimates of S&L losses in the
US were on the order of $ 600-800 bn. In the end,
the number was $ 153 bn.
 Similar experience in Sweden
Good Banks versus Bad
 Uncertainty about asset values is at the core of the
debate about good banks and bad.
 Bad Bank: The existing bank sells bad assets to a
government-funded institution and continues in
operation; if the price is high, this involves a
government subsidy. If the government has a right
of clawback, the debt overhang problem of the
existing bank is not really solved.
 Good bank: A new bank is created and gets the
assets and deposits of the old bank. The old bank
retains the equity of the „good bank“. Creditors of
the old bank share in the risk of the assets.
Procedure 2
 Art. 43 suggests that the bail-in tool is applied at
the time when the authority steps in.
 The article refers to debt instruments being written
down or converted into equity. This is done on the
basis of the valuation at the time of resolution.
How does this relate to write downs/conversions
on the basis of valuations ex post?
 The bail-in tool is to be applied only if there is a
reasonable prospect of recovery. What if the
prospect does not materialize, th ebank is
liquidated, and ex post values differ greatly from
valuations at th etime of resolution? Liability?
BRRD Exemptions from Bail-Ins
 Statutory exemptions
 Covered deposits
 Secured liabilities including covered bonds and
derivatives (up to value of collateral)
 Liabilities to (financial) institutions with an original
maturity of less than seven days
 Trade credit
 Additional exemptions „in exceptional
circumstances“ at the discretion of the resolution
authority subject to certain conditions (time scale
for bail-in, systemic risk, contagion)
 Funding by resolution institution/restructuring fund
Comments on BRRD Exemptions
 Unqualified exemptions for secured liabilities
create incentives for asset encumbrance
 Unqualified exemptions for short-term funding
from other financial institutions create incentives
for short-term wholesale money market funding –
the Dexia and HRE strategy
 Additional exemptions at the discretion of
resolution authorities create room for protecting
politically favoured creditors – the HRE policy
again
Resolution Fund Support for
Additional Exceptions
 Should come in only after a contribution of not less
than 8% of total liabilities including own funds has
come from equity holders and holders of other
eligible instruments
 Must not exceed 5 % of total liabilities including
own funds
 Can be financed from existing resolution fund, new
levy (for three years), „alternative financing
sources“
 Further funding may be provided beyond the 5%
limit, if ALL unsecured liabilities other than
deposits have been written down or converted
Minimum Requirements for „Own
Funds and Eligible Liabilities“
 Can be set by authority (8%?)
 Eligible liabilities = any (?) liabilities that are not
subject to exemption from bail-in
 Subject to bail-in in the form of conversion or
write-down
 To be contractually specified
 ... pre-specified, as in Liikanen, cocos, etc.?
 ... Or subject to rules of insolvency law?
 Question: Is a standard unsecured 5-year bond an
eligible liability? Even if it is old and has no
reference to bail-in in the contract?
Comments
 8 % „eligible liabilities“ – are we to assume that 92
% is immune from bail-in?
 „Bail-in“ is nothing but the simple principle that, if
equity is negative, creditors get what is left.
 If we accept the view that „bail-in“ is special, we
will never get back to a regime where banks‘
creditors take care as to where they put their
money.
 Treating xyz loans as special invites regulatory
arbitrage.
Open issues:
Cross-Border Resolution
 Lehman Brothers: UK authorities found that there
was no cash
 Multiple-entry resolution destroys organizational
integration
 Destruction of systemically important operations
 Single-entry resolution raises serious issues of
distribution of losses – ring-fencing
 Living will of Deutsche: US authorities should trust
Bafin
 Bafin 2012: Unicredit Germany must not provide
liquidity support to Unicredit Italy (the parent)
Cross Border Resolution in BRRD
 In principle a multi-entry approach, but there is a
college of resolution authorities
 Under the SRM (euro area) there is a single
resolution authority, but this is byzantine internally
 SRM does not include UK
Open issues: Funding
 Insolvency law: New lenders get priority old
lenders are frozen – this is enough to maintain
operations
 Not workable for banks: Freezing of old lenders
such as depositors or money market funds has
strong systemic effects
 Moreover, short-term funding is so large that even
with priority, it is seriously at risk – see repo runs
on Bear Stearns and Lehmans
 Exempting secured lending and short-term lending
from bail-in does not ensure that short-term
funding remains available
Funding in BRRD
 Issue is not addressed
 There seems to be a presumption that after bail-in
short-term funding is forthcoming again
 No remedy if mmmf‘s flee
 ECB as a lender of the last resort?
 Lending if there is a solvency risk?
 Some member states may allow for loans from
Treasury (as Dodd Frank does in US) but this is
unclear.
 Support from ESM? From Single Restructuring
Fund? Numbers are small
Open Issues: Backstop
 „The industry should pay for itself“
 Restructuring fund (based on industry levy)
 Deposit insurance institutions (based on industry
levy)
 Bail-ins
 ESM may lend ...
 Imposes risk on taxpayers
 Possibly not sufficient
Open issues: Exit
 Most of the directive assumes that institutions
should be led to recovery.
 Little about liquidation
 ... To be transferred to an insolvency procedure?
 What is the relation to insolvency law?
 A major problem of the industry is that there is too
much capacity, probably too many zombies and no
viable/credible/politically accepted exit mechanism
 Forbearance/recapitalization as the most likely
strategies