Jun 03, 2013
During the financial crisis, a number of financial institutions reached the point of failure or failed outright. The stated capital levels of these institutions typically exceeded minimum regulatory requirements, but the market doubted that those levels were enough to cover potential future losses. The suspicions of future insolvency brought these institutions down through a lack of current liquidity: depositors and other creditors demanded immediate repayment, and the institutions ran out of funds to satisfy the demands.
Governments considered many of the institutions that reached the point of failure to be “too big to fail” (TBTF). That is, they were so big, complex and interconnected with the rest of the financial system that the public cost of allowing them simply to go out of business was judged to be too high. In the absence of any alternative mechanism to restore their viability, governments themselves recapitalised these TBTF entities – using taxpayers’ funds.
Besides imposing direct costs on taxpayers, publicly funded bailouts generate significant moral hazard. Expectations of government support can amplify risktaking, reduce market discipline and create competitive distortions, further increasing the probability of distress. These concerns have prompted efforts to reduce the likelihood that TBTF institutions will fail, mainly through requirements for them to maintain higher levels of capital and liquidity and through greater supervisory attention. But these measures do not answer the question of how to pay for recapitalisation if such entities reach the point of failure. If taxpayers are to avoid this cost, the shareholders and creditors of the failed institutions must bear it, but how?
In recent years, authorities have made significant efforts to improve resolution schemes. Their initial efforts have focused on obtaining legal authority to resolve domestic and global TBTF financial entities without the use of taxpayers’ funds. These efforts include the requirements of the Basel Committee on Banking Supervision regarding the loss absorbency of capital “at the point of non-viability” and the key attributes of effective resolution schemes developed by the Financial Stability Board. Resolution powers alone, however, are not enough. Indeed, uncertainty regarding their use may itself pose a threat to financial stability.
What has yet to be sufficiently developed is clarity on the rights of private sector claimants in the resolution of a failing TBTF bank: depositors and creditors must have a guarantee that, in any attempt to recapitalise a TBTF bank by imposing losses on shareholders and creditors, the hierarchy of claims will be respected. Depositors insured prior to resolution must continue to be insured afterwards; likewise, creditors whose claims were senior or ranked equally to other claims prior to resolution must be treated accordingly in resolution. In short, a resolution scheme for a TBTF bank must respect the hierarchy of claims that existed before the institution reached the point of failure.
This article proposes a template for a simple approach – which we term a creditor-funded recapitalisation mechanism – that national authorities could employ to clarify the allocation of losses when a TBTF bank needs to be recapitalised. The proposed approach enables recapitalisation over the course of a weekend without the use of taxpayers’ money. It uses a temporary holding company to ensure that these losses are allocated in a way that strictly follows the creditor hierarchy, and it uses the market itself to determine the losses creditors need to bear to recapitalise the bank.
The proposed mechanism includes elements of other resolution methods, such as bail-in and holding company resolution (described below). As such, it is offered not necessarily as a replacement for these other methods but as an additional approach that provides clear direction on the central issue of recapitalisation for TBTF banks that reach the point of failure. As with other approaches, various detailed operational and legal questions need to be answered before the creditorfunded recapitalisation mechanism could be implemented; this article focuses on the benefits of the proposed mechanism’s overall structure and suggests a staged approach to settling the operational and legal issues.
*Download the full template here.
Re-disseminated by The Asian Banker