Opinion

Felix Salmon

Imposing a haircut on secured bank creditors

By Felix Salmon
October 6, 2009

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.

Comments
8 comments so far | RSS Comments RSS

So the haircut is a feature, not a bug?

How is this different from using subordinated debt as a regulatory tool and perhaps lever?

Posted by bdbd | Report as abusive
 

if they are senior debtholders to depositors, their debt is senior to depositors. if you don’t like that concept, don’t allow bank debtholders to be senior to depositors, at least to FDIC insured depositors.

the fact that derivative counterparties have senior claims to depositors is a much greater issue.

Posted by q | Report as abusive
 

Felix, they are called SECURED CREDITORS for a reason.

Limiting them to an arbitrary number — 80%? 20%? 0!? — means they are no longer secured.

What you are advocating is eliminating an entire class of lending . . .

 

Putting limits on sr debt sounds like a prudent move to protect depositors, especially, as q points out, derivatives counterparties get to jump to the head of the queue, although that may change based on the Lehman CDS case.

If derivatives counterparty payables are reported as Sr debt (I’m not sure where they’re reported under FASB) it shouldn’t be very hard to iron out the wrinkle you describe. That number can be volatile and can be easily monitored on a real time basis by the regulators. Sr bondholders should be provided with that information anyway since it would have a significant effect in the event of default.

Posted by michaelc | Report as abusive
 

Barry, well, yes, exactly. Getting rid of the entire class of secured lending to banks is I think a very good idea.

Posted by Felix Salmon | Report as abusive
 

I think this was Bair’s indirect way of trying to get other regulators/lawmakers to encourage Banks to reduce their reliance on short-term funding. Why because the FDIC stands behind the guys with repo claims (made by other banks acting as counterparties lending short term cash)in the case of a wind down or bankruptcy. Repo guys lucked out when the BAPCPA extended safe harbor provisions and they could amp up collateral calls without worrying that the bankruptcy court could jump in and stop them from bleeding out the cash first.
Question is how out of whack has the BAPCPA changed bankruptcy law in favor of private creditors?
Joseph Mason, senior fellow at the Wharton School, thinks the popular media’s knee-jerk reaction to Bair’s remarks in Turkey show that many market observers and policymakers are still in the dark about how important the repo issue is when we talk about ‘keeping skin in the game’. Mason wrote to clients today, “So what the FDIC is struggling against is really a violation of absolute priority, memorialized by BAPCPA, that puts traditional bank assets squarely out of the reach of the deposit insurer.”
I honestly wish She-Bear would just come out and say exactly what’s on her mind. That her peers in the regulator game have virtual hid from real policy reforms that deal with repercussions of big bank failures in any meaningful economic way.

 

Felix, I hope you do understand that the move to limit securitisation will eventually translate to higher interest rates to compensate for the high risk posed. This will add on to the liquidity issue that is faced by the real markets and solve nothing at all. Its not so much the securitisation that kills companies. Its exorbitant interest rates that does.

Posted by Winston | Report as abusive
 

Great solution: Senior debt has a whole different meaning when the gov’t serves to void moral hazzard. This 80% rule could really benefit the banking system by forcing banks to borrow more prudently and not short term. Introduces a bit of market discipline to those lending the funds as well.

Posted by sechel | Report as abusive
 

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