Imposing a haircut on secured bank creditors

By Felix Salmon
October 6, 2009
a provocative and very interesting idea which few people seem to have picked up on: when a bank fails, its secured creditors should be limited to getting only 80% of their money back:

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Sheila Bair, in Turkey, came out with a provocative and very interesting idea which few people seem to have picked up on: when a bank fails, its secured creditors should be limited to getting only 80% of their money back:

She said curbing claims would encourage secured creditors, who are protected from losses when a bank fails, to more closely monitor the risks a bank is taking and could speed up the process when an institution needs to be wound down…

“A major advantage is that all general creditors could receive substantially greater advance payments to stem any systemic risks without the extensive delays typically characteristic of the bankruptcy process,” she said.

“Obviously, the advantages and disadvantages need to be thoroughly vetted. In any event, there is a serious question about whether the current claims priority for secured claims encourages more risky behavior,” Bair added.

I like this idea, if only because secured funding at banks is invidious, especially from the point of view of someone like Bair, who exists to protect deposits. Depositors are senior to unsecured creditors, so lenders love to jump the queue, as it were, and become secured creditors instead, thereby becoming senior even to depositors. It’s an easy way of being lazy, and not feeling the need to underwrite billions of dollars in loans.

One wrinkle might be the difficulty in separating secured lenders, on the one hand, from simple trading counterparties, on the other; Bair is surely right that any mechanism along these lines should be implemented very carefully. But the bones are good, and global regulators trying to piece together a new regulatory architecture would do well to take this idea very seriously.

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