Introduction
Prior to the recent financial crisis, the failure of a bank would in most countries be treated under the standard law of bankruptcy applicable to all institutions. Standard bankruptcy law is, however, best suited to those instances where the bulk of the assets are fixed, real assets, property, land and buildings, or equipment, such as railroad lines, steel furnaces, or airplanes—assets whose nature and value are not affected by the process of bankruptcy itself. Then the bankruptcy can, and does, involve a process of finding a (highest bidding) buyer for the unchanged real assets who can take them over and use them again productively.
The more a business is built on such real assets, with a relatively assured and stable second-hand resale price, the more appropriate is debt finance, limited liability equity finance, and a continuing market, via takeovers, for ownership in that equity market.
Bankruptcy procedures and governance structures may need to become more complicated when the institution is primarily based on intangible capital—intellectual know-how—rather than on real tangible assets. Examples are legal and accountancy firms, advertising agencies, medical practices, universities, etc. In such cases, with no or little ability to constrain and to pre-commit the staff, who possess the human capital, by indenture or by slavery, the gone-concern value of such an institution is often a tiny fraction of its potential going-concern value. In such a condition, debt is, in general, not such an appropriate financing vehicle (on what would it be based?), a market for ownership of the institution is more problematical, and partnerships, of some form, are more suitable than a (limited liability) equity base. Normally, however, the failure of one such service provider strengthens its competitors in the market. Not only is competition for their output reduced, but they may also be able to pick up displaced and unemployed skilled staff more easily from the failing firm(s). As a generality, the failure of a service provider does not lead to contagion in that sector, whereby the failure of one firm drags others down with it.
Much of the value of a bank lies in the intangible value of being able to allocate funds wisely to good investments. It provides financial services, mainly based on the utilization of
human rather than fixed capital. Moreover, should the bank be forced to realize its assets (or to call in its loans) in order to meet withdrawals, such pressurized sales will worsen the position of other similar banks in a variety of ways—for example, via the interbank market, by causing fear among depositors, by reducing the market value of their assets, and by damaging the general economy. Thus, the failure of one bank can have a contagious impact on other banks, the more so the greater the perceived similarity between the failing bank and others like it, which may often be aggravated by microprudential policies that encourage self-similarity among banks. With banks undertaking maturity mismatch, they are bound to depend, more or less, on confidence in their continued operation. The standard bankruptcy procedure will damage such confidence not only in the bank being liquidated, but also in other banks that are perceived as similar.
The potentiality for contagion as banks began to fail during the recent crisis soon became obvious (Northern Rock, Lehman), and led to a variety of crisis measures, such as guarantees of bank creditors, both depositors and bondholders, and to forced state recapitalization of banks. But such measures were expensive to taxpayers, at least initially, and remained so in some cases, and were resented as they represented a transfer from poorer taxpayers to wealthier bankers, and to bank bondholders. The cry has gone up: “This must never happen again.”
To some degree, an institution, such as a bank, dependent on both intangible human capital and subject to contagion when confidence goes, might seem better suited to a partnership, with or without some limit to liability. The problem with partnerships is that they restrict the equity capital that can be deployed and, hence, the size of the institutions. Where there appear to be economies of scale, though their extent in banking is a contentious issue, there will be pressure to transform into a publicly listed limited company in order to become larger. In any case, contagious failure was rife in systems with large numbers of poorly capitalized small banks, whether partnerships or limited liability entities, such as the country banks in the UK in the first half of the nineteenth century or the unit banks in the USA in the interwar period. Moreover, there is always a temptation with a partnership or a mutual company to cash in one’s chips by going public.
Be that as it may (and on this view, there are grounds for reviewing the extent of the potential liability of some or all equity holders of a bank), one lesson of the recent financial crisis has been that standard bankruptcy procedures are inappropriate in the case of a bank. Instead, we need a special resolution regime (SRR) for banks, enabling the financial authorities, in the guise of an institution set up for that particular purpose (whether or not it is part of the central bank), to intervene in a failing bank to handle its demise in a variety of ways as might seem best—for example, to divide the existing bank into good/bad bank segments, to sell the (good) bank to another bank, to run the bank itself (effectively to nationalize it, though only as a temporary expedient), or, at least as a last resort, to liquidate it.
The establishment of an SRR is to be buttressed with two further reforms. The first is that the ratio of potentially loss-absorbing capital to (risk-weighted) assets should be greatly increased. There are various potential ways of doing so, either by requiring a higher equity ratio, by increasing the potential liability of (some or all) equity holders, or by forcing certain (non-equity) creditors to transform their claims into equity when
failure looms (or possibly well beforehand in the case of high-trigger CoCos). Largely because of the tax advantage of debt (relative to equity) and the difficulties banks face in raising new equity, not least because of the continuing uncertainty about the form of the regulatory framework, most attention has been paid to proposals that require banks to augment their loss-absorbing capital by issuing bail-inable bonds that transform into equity when a bank approaches failure.
The second reform involves making advance plans for periods of extreme difficulties for large and systemic banks in the shape of recovery and resolution plans (RRPs).
The first part, the “recovery” segment, requires the bank to think how it might be able to survive periods of extreme pressure (e.g. by selling assets or by borrowing, perhaps by establishing some kind of contingent put option). The second part, the “resolution”
plan, requires the bank to organize its affairs in such a way as to facilitate and expedite intervention by the official agency established under the SRR for the purpose of resolving failed banks (should the recovery part of the RRP prove insufficient).
What Should Happen?
• Stage 1: A bank gets into trouble. The prearranged recovery plan kicks in. The bank involved sells assets, or borrows as contingently arranged. Liquidity support from central bank may be needed.
• Stage 2: Assuming that Stage 1 does not suffice, and the bank continues its downward spiral toward failure. If the bank has previously established low-trigger CoCos or bail-inable bonds that are triggered when equity values fall far enough, then these would be activated so that the bank obtains sufficient equity to absorb the losses. Liquidity support from the central bank will, almost certainly, also be needed.
• Stage 3: Otherwise, the bank will enter formal resolution under the aegis of the SRR.
Then the authorities bail in the unsecured creditors with the aim of recapitalizing and refloating the bank using such funds.
• Stage 4: If the forced recapitalization from bail-ins by the SRR proves to be inadequate, then there may have to be recourse to taxpayer funds in the short run—for example, to recapitalize the bank—but the intention is that such funding should be recouped by a tax/levy on the banks, either from a fund established ex ante or a levy imposed on surviving banks ex post. The idea is that any taxpayer assistance should be strictly temporary. Again, if any such failing bank is to be reconstituted, central bank liquidity support will, almost certainly, be required.
So far, perhaps so good. What can now go wrong?
What May Go Wrong and What to Do About It Cross-border, universal banks and the point of entry
Thus far, we have been implicitly assuming that a bank is a simple institution operating within a single jurisdiction and undertaking only one version of financial intermediation
described as “banking.” What happens instead if the bank has subsidiaries, operating as separately capitalized entities in multiple jurisdictions? Alternatively, what happens if the bank has several subsidiaries, or associated companies, undertaking several different kinds of financial intermediation, again either in one or multiple jurisdictions, such as insurance, investment banking, broker/dealer, retail banking, etc.?
Currently we see two potentially conflicting directions of travel. First, there is the provisional agreement on “Resolving Globally Active, Systemically Important, Financial Institutions” between the Bank of England and the Federal Deposit Insurance Corporation (FDIC) (December 10, 2012), which proposes that above any bank—which may have subsidiaries and/or associated companies in other jurisdictions, and may also be doing other kinds of (financial intermediation) business—there should be one overall controlling holding company. This superior holding company should be the single point of entry for the purpose of bank resolution. The holding company should, in turn, be the level at which sufficient loss-absorbing capital (equity plus bail-inable bonds) be held in order to prevent or to limit taxpayer liability.
The second trend is to divide a banking business into different kinds of activities with differing contingent liabilities for taxpayers in the various cases. Thus, the (Vickers) Independent Commission on Banking would seek to ring fence a specified retail banking business operating in the UK and the rest of the EU, which the British government would be pre-committed to supporting and to maintaining. The remainder of any associated banking business, whether banking (of any kind) outside of the EU, or non-retail financial intermediation within the EU—for example, investment banking—should then not rely on any financial support from UK taxpayers. As a corollary, the differing parts of the bank would need to be separately capitalized with, for example, strict controls over the transfer of funds out of the (protected) UK retail banking entity into any other part of that business. The implication would then seem to be that Vickers, and the somewhat similar Liikanen Report, would require resolution of a banking business to be done via multiple points of entry with each segment—that is, EU retail banks, EU investment banks, and rest-of-the-world (RoW) banks going through separate bankruptcy procedures.
The single point of entry (BoE/FDIC) approach is far better suited to a globalized, cross-border, worldwide financial system. It clarifies responsibility within the authority in which the holding company is registered. Presumably, a host country could refuse to authorize a banking subsidiary headquartered in a country whose legal system or resolution mechanisms were considered unsatisfactory by the host country. Such a system should minimize disputes between the authorities in which the (failing) bank operated, since the actions would necessarily fall on the home country.
The problem, of course, has been that with insufficiently capitalized banks, the resultant contingent liability on the home country has been greater than their taxpayers could bear. The imposition of losses on what would probably be primarily domestic stakeholders through top-down bail-in would probably transfer value from domestic stakeholders to foreign creditors, and would be politically difficult. This might be acceptable if all countries were clearly committed to playing by the same rules, but there is no certainty, or perhaps even likelihood, of this. With competitive pressures, current constraints on raising equity in a recession, and the banking lobby, all limiting any (rapid)
rise in the ratio of loss-absorbing capital, the best way to limit taxpayers’ contingent liability appeared to be to distinguish between those parts of the bank that the home authority would support, if the worst came to the worst, and those that it would not.
While the incentive for such a division into multiple points of entry on resolution is clear enough, the results are likely to be untidy, and to lead, perhaps intentionally, toward greater national fragmentation and protectionism in financial intermediation.
If the home authority is to wash its hands of responsibility for the subsidiaries of one of its banks outside its own country or region, then one would expect each host country not only to require the maintenance at all times of specific local (trapped) capital and liquidity, but also to limit transfers of funds from the local subsidiary to the rest of the bank.
Meanwhile, the interconnectedness of investment banks, and hence the likelihood of contagion, is, in general, considerably greater than that of retail banks. Apart from IT and administrative problems, retail banks are relatively easy to divide into good and bad parts, thus enabling the refloating or selling off of the good parts. In contrast, the manifold market and other interconnections of investment banks make them a nightmare to liquidate, as in the case of Lehman Bros. From a macroeconomic viewpoint, the externalities and potential contagion arising from the closure and liquidation of an investment bank could be much worse than that arising from the same fate befalling an equal-sized retail bank. Thus, the economic advantages of recapitalizing an investment bank as a going concern, whether by taxpayer funds or otherwise, could well be greater than doing so for a retail bank. But the political calculus dominates the economic calculus.
Whether the single-point-of-entry (SPE) approach to resolution can survive in a financial system in which different parts of cross-border, universal banks are regulated and treated in different ways has yet to be discovered. Of course, if the SPE approach worked, and was credibly expected to work, always and everywhere, then ring fencing would be irrelevant. The fact that ring fencing is up front and central to the structural debate on the future of banking in the EU implies that there is a lack of confidence about the efficacy of the SPE approach. In what circumstances—for example, when the business of the group and its assets are so rotten throughout that it is impossible to value the size of the hole up front, which is important for determining how far to write down debt claims to cover the losses—might SPE not work?
If, in such particular circumstances SPE does not work, then the fall back to multiple points of entry (MPE) and ring fencing might help some of the subsidiaries providing
“elemental” services—that is, payments. Seen this way, ring fencing is about making an entity super-resolvable, if a group-wide SPE resolution does not work. To an outsider, the regulatory authorities appear to be trying to ride two differing horses (SPE and MPE) simultaneously. Such twin-horse riding may be doable, but it is hard for a cynical commentator to see how they can be compatible.
More or less identical issues are at stake in the continuing discussions on bank resolution within the Banking Union. If responsibility for meeting losses, beyond those that can be absorbed by bank creditors, stays primarily with the nation-state of that bank, then each state will try to limit contingent conditional liability by adopting MPE.
If, on the other hand, losses in the course of resolution are met through a European-wide
SPE mechanism—say, via the European stability mechanism (ESM)—then there will be political difficulties in achieving transfers of funds from some countries (who regard themselves as innocent bystanders) to others (who may or may not have some closer responsibility for such failings).
Be that as it may, the earlier the intervention into a failing bank occurs, the more likely it would be that the available capital could absorb the losses accrued to that date.
The timing of intervention
While early intervention may lower the cost of remedying bank failure, it may also prematurely interfere with the ownership, property, and rights of bank shareholders. So there is a need to balance the advantages both to other bank creditors and to society as a whole, against the (property) rights of bank owners (shareholders).
In the Financial Stability Board’s (FSB’s) pamphlet Key Attributes of Effective Resolution for Financial Institutions (October 2011), there is a short, three-sentence section on the timing of such intervention. It reads:
Resolution should be initiated when a firm is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so. The resolution regime should provide for timely and early entry into resolution before a firm is balance-sheet insolvent and before all equity has been fully wiped out. There should be clear standards or suitable indicators of non-viability to help guide decisions on whether firms meet the conditions for entry into resolution. (FSB 2011, 3.1)
At first sight, the first two sentences seem inconsistent, with the first sentence emphasizing the rights of shareholders to remain in control until all reasonable hope of recovery has vanished, and the second outlining the advantages within the resolution process of quick intervention. I have, however, been led to believe that the first sentence is key, with the second sentence simply acting as a qualifier. Thus, the authorities should wait until all practicable hope of recovery has gone, but, once that has happened, they should intervene immediately to resolve the failing bank. One issue is who calls the shots.
Prudential supervisors are prone to delay, whereas resolution agencies would prefer to act sooner. The forthcoming role of the European Central Bank (ECB) as a supervisor may serve to expedite the process of entering resolution.
In my view, the balance has been tilted too far toward respect for shareholders’ rights, and away from the wider interests of other creditors, and of society. Hope springs eternal in the human breast and also in that of accountants. It is extremely rare for a bank to close because the auditor has stated that liabilities exceed assets. Instead, creditors in repo, bond, and deposit markets flee, and the bank fails because it cannot find cash with which to pay its bills. Banks fail because they run out of money, not because the auditor finds their capital deficient. By the time that effective liquidity constraints force intervention, the true mark-to-market value of a bank, in such distressed fire sale conditions, may be severely under water. Thus, present proposals for the timing of intervention may be excessively careful regarding shareholder property rights.