Financial Regulatory Forum

Basel paper offers new look at bail-in models for ailing institutions

By Guest Contributor
June 12, 2013

By Bora Yagiz, Compliance Complete

NEW YORK, June 12 (Thomson Reuters Accelus) - A recent Bank for International Settlements (BIS) quarterly review article attempts to solve the too-big-to-fail (TBTF) problem without causing systemic disruption to financial markets, by offering a new resolution template to recapitalize banks on the verge of bankruptcy. It may, however, inadvertently legitimize a de facto bail-in model against the consent of depositors, and put their money at risk.

Since the financial crisis of 2008, regulators worldwide have sought to reduce the likelihood of a TBTF failure through increase in capital quality and quantity enshrined internationally in Basel III, as well as setting various resolution mechanisms set to wind down failing institutions. 

The U.S. regulators have taken two major specific steps, in the context of the Dodd-Frank financial regulatory overhaul. They have imposed prudential supervision rules with stringent capital, liquidity and leverage requirements for systemically important financial institutions (SIFIs). They have created a living-will process, where each large institution is supposed to detail its operations, its subsidiaries and write a concrete plan for how it could be wound down if it goes bankrupt. Additionally, The Federal Deposit Insurance Corporation (FDIC) was entrusted with the orderly liquidation authority to take ownership of SIFIs when they cease to be solvent.

Yet, the liquidation authority and the living will ideas suffer from a dilemma, in that the regulators will be reluctant in publicly announcing an institution’s financial death as this may cause a run on other institutions. The beefed up capital levels are, after all, dependent on the public perception of banks’ solvency, which, may well be deemed to be insufficient in time of crisis. Neither of these measures answers the questions of how the recapitalization would be funded, and how the losses would be allocated among debtors and creditors.

The article is by Paul Melaschenko and Noel Reynolds, members of the secretariat of the Basel Committee on Banking Supervision. The authors seek to clarify the clarify these questions by advocating a creditor-funded resolution mechanism, whereby taxpayers would not be on the hook in case of the bank’s failure. Instead, the authors of the article argue, the shareholders and the uninsured creditors would have to fill in the gap, all the while respecting the hierarchy of claims that existed before the occurrence of the failure. Critically, this process would take place over a weekend, thus leaving less room for a possible financial contagion.

Specifically, ownership of the SIFI that reaches the point of failure would first be transferred to a new holding company. The resolution authority would then write off all of the subordinated liabilities, along with some of the senior unsecured uninsured liabilities, for which the authority would have to make the calculations. The equity, and the written-off liabilities would be transformed as the new claims of the failed bank’s investors as liabilities and equity of the new holding company. After the weekend cleanup, the SIFI would open for business as a going concern, and the recapitalized holding company would be put up for sale, the proceeds from which would be distributed to the former investors of the creditors.

Purportedly, the proposal, if implemented, would resolve the moral hazard problem without the use of taxpayer money and alleviate the burden related to any type of complexities arising from other resolution regimes. The model would also respect a creditor hierarchy where the proceeds from the sale would go to senior creditors, subordinated creditors and shareholders, and in that strict order. This would be in similar fashion to a loss distribution of a collateralized debt obligation, where the junior tranches (like subordinated creditors or shareholders) would bear the risk of being wiped out and the senior tranches (like senior creditors) would get repaid first.

Drawbacks

An examination of the proposal reveals five major drawbacks.

First, this three-step model (recapitalization of the bank, transfer of losses to a holding company, and the sale of the bank) is a hybrid form of two resolution schemes. On the one hand, it has elements of a single point of entry, where a resolution authority would create a bridge holding company and allocate losses to shareholders and unsecured creditors through debt write-off (see explanation above).

On the other hand, it resembles the bail-in scheme, where the funding comes from within and not from without. The creditor-funded model goes further than a typical bail-in model, however, where there is an agreement by creditors to roll over their claims or one that allows some form of formal debt restructuring. The model suggests the use of depositors’ funds and their conversion into common shares in the newly created holding company without their explicit consent. This would be akin to a case where a contingent convertible bond would convert into stocks automatically without the bondholder’s use of that conversion optionality.

Second, the model does not offer any method for the debt write-off calculation. It is difficult to conceive that a regular expected loss calculation method based on a multiplication of loss given default, probability of default, and exposure at default would be possible over a weekend given the complexity of the institution’s business operations and the high level of its interconnectedness.

“When alive, banks’ risk management are done through business lines, but when they die, they are resolved by legal entities,” said Mayra Rodriguez Valladarez, Managing Principal of MRV Associates, underlying the difficulty of parsing out the operations of a complex institution at the time of bankruptcy.

Third, the model deemphasizes the consequences of a possible miscalculation in the amount of write-offs. Indeed, the authors count on the self-correction mechanism of the market. They argue that even if the regulators decide to write off a significant portion of the claims, the proceeds from a subsequent sale of the bank would be higher anyway, owing to its now well capitalized position. This would then translate into more funds to distribute to creditors who had previously suffered from the high level of write-off. Such use of market valuation in determining creditors’ loss allocation through the price of the newly capitalized bank heavily depends on liquidity and market depth at the time of sale, neither of which can be ascertained in advance.

Fourth, it is unclear how a regulatory agency in charge of the resolution could give unequivocal assurance that the insured deposits will be fully protected during the recapitalization process. In many jurisdictions, these assurances are provided through deposit insurance schemes. In the United States, for instance, Dodd-Frank had established a minimum designated reserve ratio of 1.35 percent of estimated insured deposits, and increased it to 2 percent by 2011. However, the deposit insurance schemes may not be sufficient to cover the possible losses and may also create another type of a moral hazard by attracting money from foreign depositors who lack such a scheme in their own country, thereby straining the viability of the system further.

Lastly, a rapid recapitalization mechanism faces difficulties in practice, given the lack of a common set of too-big-to-fail criteria, and the complexity of a resolution mechanism for an institution with vast international operations under different jurisdictions.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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