Tag Archives: Resolution mechanism

Banking Union

Willem Buiter, Ebrahim Rahbari and Antonio Montilla provide a detailed assessment of the need for a Euro Area banking union and the progress towards it, in a Citi Research document. Some excerpts from the abstract:

… a single supervisor, a common resolution mechanism, including a joint recapitalisation back-up, and an effective lender of last resort – is necessary for the euro area (EA) to survive.

The CA’s [comprehensive assessment’s] conclusion will likely boost EA financial conditions in coming months. Even so, we believe the CA should have been more stringent, current backstops are still inadequate, and the CA will not eliminate divergences in financial conditions …

Remaining elements of narrow banking union are also very important — These are the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). In particular, the SRM and its bail-in provisions should materially reduce the likelihood that an EA sovereign will be dragged into insolvency through tax-payer-funded bank bailouts. Reduced moral hazard will also likely lower the likelihood and severity of future banking crises. And the combination of CA, SSM and SRM are also likely to mean that the ECB will be an effective lender of last resort for EA banks (and sovereigns).

… one key fragility remains: excessive two-way links between national sovereigns and banks. Risk-weighting of sovereign debt and concentration limits on sovereign debt holdings by banks are necessary to break these links.

A single deposit guarantee scheme is not necessary for monetary union and requires a deeper fiscal union than the minimal common backstops required to make monetary union work. It is therefore unlikely in the foreseeable future, in our view. An EA sovereign debt restructuring mechanism (SDRM) may be necessary to handle legacy sovereign debt restructurings and possible future sovereign insolvencies, but beyond the limited mutualised fiscal backstops necessary for banking union and the SDRM, deeper fiscal union is neither necessary for EA survival nor likely, for political reasons, in the foreseeable future.

The report contains many interesting figures, for example on the exposure of banks to their domestic governments; the correlation between sovereign and bank CDS spreads; lending standards; the share of bank loans in banks’ balance sheets etc.

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.

IMF Discussion Note on Banking Union in the Euro Area

Rishi Goyal, Petya Koeva Brooks, Mahmood Pradhan, Thierry Tressel, Giovanni Dell’Ariccia, Ross Leckow, Ceyla Pazarbasioglu et al discuss the case for a banking union in the Euro area in an IMF Staff Discussion Note. The authors argue in favour of both a single supervisory-regulatory framework and a common resolution mechanism as well as safety net.