Tag Archives: Seniority

Report on the Irish Banking Crisis (And the ECB’s Role)

In the Irish Times, Colin Gleeson summarizes the findings and recommendations of the main Report of the Oireachtas Banking Inquiry. They are:

  • Incentives were distorted.
  • Banks and the property sector ran out of control.
  • Regulators were too optimistic.
  • “IMF favoured imposing losses on senior bond holders in October/November 2010.”
  • “No Troika programme agreed in November 2010 if Government burned senior bond holders.”
  • “ECB position contributed to inappropriate placing of significant banking debts on Irish citizens.”

Sovereign Debt Seniority

In a Vox column, Matthias Schlegl, Christoph Trebesch, and Mark Wright document an implicit seniority structure of external sovereign debt: IMF > Multinational > Bonds > Bilateral > Banks > Trade Credit (see the figure).

They argue that Greece’s recent default on the IMF constitutes an outlier.

… Greece in 2015 is clearly an outlier case, having defaulted on the most senior creditor (the IMF), while continuing to service historically more junior creditors. The evidence also suggests that the Eurozone rescue loans, which are essentially bilateral (government-to-government) credit, are likely to be a junior creditor class going forward. The evidence also rationalises why Greece may have an interest in exchanging the debt it owes to the IMF and the ECB into loans to the European Stability Mechanism, which is likely to be junior debt in the future, as discussed in the run-up to the July Eurozone summits. Policymakers should be aware of the associated changes in seniority and repayment incentives.

trebesch fig3 7 aug

Large Banks Promise not to Terminate Distressed Derivatives Contracts

Philip Stafford and Tracy Alloway report in the FT that under the stewardship of the International Swaps and Derivatives Association, large banks

have agreed to give up their rights to immediately end derivatives contracts with crisis-hit rivals after global regulators pressed for an industry cross-border agreement to stop counterparties terminating deals with troubled institutions.

The agreement covers 90% of the OTC derivatives market. Incentives to live up to it are weak; not amending one’s contracts with counter parties amounts to the dominant strategy in a prisoners’ dilemma situation. Moreover, institutional investors may have fiduciary duties to end their contracts if a counter party defaults so attaining the cooperative equilibrium may not be possible without legal changes.

DN: But if the initiative succeeds, could it undermine the effective seniority status of derivatives?

Conference on “Law and Economics” with Focus Session on “Bank Resolution” at the Study Center Gerzensee

Joint with CEPR, the Study Center Gerzensee organised a conference on law and economics. The program can be viewed here and papers can be downloaded from CEPR’s website. The focus session on bank resolution featured contributions by

  • Patrick Bolton and Jeffrey Gordon (paper)
  • Martin Hellwig (paper, slides)
  • Mathias Dewatripont (slides)
  • Gerard Hertig
  • Wolf-Georg Ringe (paper)
  • Paul Tucker (paper)

In his talk, Jeff Gordon explained how Dodd-Frank extends the FDIC’s resolution technology from the 1930s to “non-banks” that engage in banking business. Dodd-Frank establishes an “Orderly Liquidation Authority” and in title II a “Single Point of Entry” by putting a holding company (topco) into receivership. The objective is to minimise disruption costs for large institutions, to preserve the going-concern value of the company and to avoid collateral damage. Single point of entry also helps resolve cross-border issues. No comparable institutional framework is available in the EU. In the crisis, US authorities implemented ad-hoc alternatives to bankruptcy: Mergers (which require the approval of shareholders and therefore make it hard to wipe out the target’s shareholders) worked for Bear Stearns (JPMorgan Chase, Maiden Lane, Fed) but not for Lehman Brothers (Barclays, Fed) because the UK authorities refused to waive Barclays shareholder approval, fearing fiscal implications. Recapitalisation with third party funds (Fed) in the case of AIG also required shareholder approval and protected creditors and counter-party claims.

Patrick Bolton cautioned that the rules for the topco are still not clear and discussed alternatives to Dodd-Frank in the bankruptcy code. He emphasised the role of qualified financial contracts and debtor-in-possession interventions.

Martin Hellwig argued that the government rescue of Hypo Real Estate reflected the political will to help influential creditors rather than systemic importance. He questioned the viability of single-point-of-entry arrangements in cross-border resolution, pointing to lack of trust among national regulators. He questioned whether internationally active banks can ever be resolved in an efficient manner and asked whether, in that light, they are socially valuable.

Mathias Dewatripont warned that excessive emphasis on bail-in arrangements can undermine financial stability, for example by having the expectation of a small haircut applied to senior debt tranches trigger a run on all senior debt. To avoid such an outcome, he favoured a clearly identified seniority structure with a significant balance-sheet share of “bail-inable” liabilities. He questioned the usefulness of higher capital requirements, arguing that “prompt corrective action” is politically infeasible unless the equity ratio has fallen below a very low value, 2 percent say.

Wolf-Georg Ringe favoured holding-company structures with sufficient “bail-inable” debt.

Paul Tucker discussed potential problems with the holding-company/single-point-of-entry strategy, related to centralised operations (IT). He raised the issue of accountability and the potential lack thereof if companies are resolved by regulators rather than judges, and he wondered whether national regulators can commit to collaborate across borders if need be. He favoured “bail-inable” debt over equity because the former gives incentives to monitor without the incentive to speculate on the upside.

Gerard Hertig warned that regulatory incentives lead to bank mergers rather than resolution, in particular because authorities tend to be more lenient in crisis times. He argued that because of deposit insurance, resolution worked well in Japan until recently.

Patrick Bolton argued that cocos are badly designed as their triggers are too low and they refer to accounting equity. Instead, he favoured reverse convertible bonds that can be converted by the issuer.

Oliver Hart argued that resolution has the advantage over cocos that the management gets replaced.

Many panelists voiced scepticism towards narrow banking proposals. They feared that control over the money supply might turn into control over credit, referring to the discussion in the US during the 1930s.