Getting Bank Insolvency Resolution Right is Key to Banking Stability in the EU

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Getting Bank Insolvency Resolution Right is Key
to Banking Stability in the EU

• George Kaufman
• Loyola University Chicago and Federal Reserve
  Bank of Chicago
• ECB-Bank of Spain Conference
• Madrid, Spain
• December 1, 2006

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Narrative

• Single most important component of regulatory
  strategy for banking stability is resolving
  insolvent banks efficiently with minimum, if any,
  credit loss (CL) and liquidity loss (LL)
• CL MVAltMVD MVKlt0
• LL Delay in access to most bank activities and
  legitimate claims on bank.

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Narrative (cont.)

• Direct and contagion/adverse externality costs of
  bank insolvency greater, greater are CL and LL.
  Eliminate CL and LL, little contagion
• Allocation of CL between uninsured claimants and
  insurer (government) also impacts failure costs
  thru market discipline and moral hazard

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Efficient Resolution Strategy

• Use PCA to turn troubled banks around before
  insolvency. If fail, prompt mandatory legal
  closure (revoke charter, place in receivership)
  at positive capital closure rule (regulatory
  insolvency). Avoid/minimize CL.
• Estimate any credit losses promptly and allocate
  pro-rata across depositors and other claimants
  according to ex-ante legal priorities
  (loss-sharing). Insurer assumes loss for insured
  depositors. Enhance market discipline.

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Efficient Resolution Strategy (cont.)

• Prompt seamless (next day or so) transfer of
  activities to liquidation agency, purchasing
  bank, or new bridge bank
• par value of insured deposits,
• estimated recovery value of uninsured deposits,
• Existing lines of credit of performing borrowers
• Avoid/minimize liquidity losses. (No physical
  closure, separate legal from physical closure.)
• Re-privatize any bridge banks created promptly at
  sufficient capital.
• Must publicize strategy widely to make credible
  and affect ex-ante expectations/behavior and
  enhance regulatory accountability. Secret plans
  likely ineffective.

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Problems

• Requires
• favorable legal bankruptcy code and environment
  (separate code for banks)
• timely and accurate data collection, processing,
  and sharing
• quality supervision
• political will and ability to implement and
  enforce provisions efficiently

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Problems Unique to Cross-Border Banking in
EU(Branches and Subsidiaries)

• Problems more difficult because
• multiple national prudential supervisors
• multiple and different national bankruptcy codes,
  including timing of legal closure
• few efficient bankruptcy codes
• multiple and different national deposit insurance
  agencies, schemes, and funding credibility
• need for cross-border data sharing
• different quality national supervision and data

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Problems Unique to Cross-Border Banking in EU
(cont.)

• Worsened further for foreign branches in EU
  because pain of insolvency impacts host country
  but deposit insurance and winding up schemes
  controlled by home country. In periods of
  strain, cooperation among affected countries
  likely to break down and regulators resort to own
  country loyalty. Will act to minimize own
  country losses and shift losses to other
  countries thru timing of legal closure,
  allocation of credit losses to countries, path
  and speed of insolvency resolution, payment of
  deposit insurance, use of PCA, etc. Poor
  incentives for national regulators to do right
  thing in troubled times when it matters. Thus
  more serious home-host country conflicts and
  tensions.

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Problems Unique to Cross-Border Banking in EU
(cont.)

• Efficient insolvency resolution of large
  cross-border branch banks less likely with
  greater resulting uncertainty and chance of
  delayed (non-prompt) resolution with full
  protection of all creditors by home or host
  countries at, on average, high current and future
  societal costs.

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Solution

• Single EU deposit insurance agency and common
  efficient bank bankruptcy code---but unlikely
  soon.
• Cooperation, but breaks down in bad times.
• If can eliminate CL and LL, cross-border
  home-host conflicts less serious.
• Thus, for cross-border banks with branches, could
  possibly tie PCA and efficient resolution scheme
  to single UE banking license. No taking,
  covenant like any insurance company requires on
  policies condition of special license. May need
  to enhance carrots to entice banks to agree.
  Provisions, including CR, those of home country,
  if meet specified minimum conditions.

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U.S. Bank Bankruptcy Code

• Separate from general corporate code
• Very different provisions recognizing actual or
  perceived differences between banks and most
  other corporations.

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Major Differences Between General Corporate and
Bank Insolvency Codes
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Major Differences Between General Corporate and
Bank Insolvency Codes (cont.)