Towards a new framework for bank resolution

Xavier Freixas, 1 September 2012

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The current crisis has triggered key changes in the European banking resolution regime that were long overdue. Banks’ bankruptcy legislation is changing rapidly in Europe, facilitating an orderly and speedy resolution of banks in distress. Examples include the 6 June European Commission proposal (COM 2012 280/3) for a directive establishing a framework for the recovery and resolution of credit institutions, the recent Memorandum of Understanding to cope with the Spanish banking crisis that pointed to a fundamental transformation in the management of banking crises, and the 2010 Danish Act on Financial Stability.

  • Prior to 2007, the generally accepted view was that systemic banks were to be bailed out.
  • Nowadays, the prevailing opinion is instead that some liability holders have to be penalised, thus reducing the cost of banks’ resolution.

Some recent studies have shed light on this alteration of the regulatory standpoint. We argue that the new regulatory framework is crucial in order to improve the efficiency of the banking system.

To grasp the intricacies of bank resolution it is helpful to recall the classical view on debt and bankruptcy. Indeed, bankruptcy is intrinsically associated with the existence of debt as a hard claim. The existence of debt is justified because of the ex ante incentives generated by the threat of bankruptcy and the corresponding market discipline it provides (Jensen 1986, Hart and Moore 1995). This implies that the renegotiation of debt terms should not be easy, as otherwise it would lead to a ‘soft budget constraint’.

Ex ante incentives and ex post efficiency

At the same time, the bankruptcy literature (Bebchuk 1988 or Aghion et al. 1992) has devised schemes that try and induce ex post efficiency, i.e. the maximisation of creditor proceeds in bankruptcy (as well as the respect of priority rules). Yet the pursuit of ex post efficiency may be attained by automatic recapitalisation rules or debt-equity swaps that will erode the ex ante incentives. Consequently, there is a trade-off between ex ante incentives and ex post efficiency that has to be taken into account in the design of bankruptcy rules.

When it comes to banking, the tension between ex ante incentives and ex post efficiency is not the same. Indeed, because of the risk of contagion, the ex post social cost of a bank bankruptcy is higher than the one of non-financial firms while the existence of banking supervision was expected to rein in moral hazard. This led regulatory authorities to agree that banks were to be bailed out if and only if they were systemic.

The crisis has shown that under the existing framework (often based on a general bankruptcy law covering both financial and non-financial institutions) regulatory authorities had no choice but to resort to a generalised bailout, as it occurred in Ireland. Recent contributions have shown that, in spite of banking supervision, banks took excessive risks.1

At the level of corporate governance, evidence on the managers and shareholders incentives to take risks have been obtained by Ellul and Yerramilli (2010) and Laeven and Levine (2009). The former find that the structure of risk management in the organisation is key in determining banks’ risk taking. The latter obtain that banks with more powerful owners tend to take more risks, so that the issue of incentives is not just restricted to managers’ incentives, but affects also shareholders.

Designing a bank resolution mechanism

The question is therefore whether it is possible to define bank resolution mechanisms that preserve ex ante incentives while limiting the ex post inefficiencies. This is obtained by resorting to a different contractual approach to banks’ distress.

In a recent paper, we argue that the best way to analyse a bank resolution situation is to think of it as a bargaining game between the bank’s shareholders and the treasury (Dewatripont and Freixas 2012).

When a bank is in distress:

  • The bank resolution framework in place at t=0 provides the mechanisms the treasury is able to implement;
  • The bankruptcy procedures at t=2 define the disagreement outcome of the game

As usual, this second stage determines the equilibrium of the game at the start.

In the absence of a bank specific bankruptcy procedure, because the Treasury aim is to preserve financial stability, both debt holders and shareholders have strong incentives to reject any offer that is not a complete bailout.

The strategic dimension of bank resolution means that, in order to be credible, a bank bankruptcy not only has to be characterised by legal certainty, allowing for a speedy resolution and reducing the threat to financial stability, but also has to be renegotiation proof.

Once the banks’ bankruptcy procedure is well established, it is possible to design at the preventive stage (t=0) a number of bank resolution procedures that, otherwise, would have been rejected by shareholders. Such bank resolution mechanisms can:

  • Operate either through asset revaluation or through a liability devaluation;
  • Contemplate a swap of different types of liabilities; and
  • Involve the separation of a bad bank from a good bank or not.

The recent proposal of contingent convertibles (cocos) and bail-ins enters this category of mechanisms, as they trigger an automatic recapitalisation of banks in difficulty (on this see Goodhart 2010). Still, from the point of view of the existing trade-off between ex ante incentives and ex post efficiency there is a key difference: while cocos dilute ex ante incentives, bail-ins constitute hard claims that imply a specific burden sharing for ‘non contagious’ liability holders. The recent European proposal is fully in line with this view.

References

Aghion, P, O Hart, and J Moore (1992), “The Economics of Bankruptcy Reform”, Journal of Law, Economics, and Organization, 8:523-546. 

Dewatripont, M, and X Freixas (2012), “Bank Resolution: Lessons from the crisis” in M Dewatripont and X Freixas (eds.), The Crisis Aftermath: New Regulatory Paradigms, Centre For Economic Policy Research.

Farhi, E and J Tirole (2009), “Leverage and the Central Banker’s Put”, American Economic Review, Papers and Proceedings, 99(2).

Goodhart, C (2012), “Are CoCos from Cloud Cuckoo-Land?”, VoxEU.org, 10 June.

Hart, O, and J Moore (1995), “Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management”, American Economic Review, 85:567-585.

Jensen, MC (1986), “The Agency Costs of Free Cash Flow: Corporate Finance and Takeovers”, American Economic Review, 76.

Laeven, L and R Levine (2009), “Bank governance, regulation, and risk-taking”, Journal of Financial Economics, 93:259-275


1 This was shown by Farhi and Tirole (2012) who pointed out that private leverage choices are strategic complements and consequently the anticipation of a 'monetary policy bail-out' reinforces the tendency of banks to herd in increasing their maturity mismatch.

Topics: Global governance, International finance
Tags: bank resolution, banking crises, Bankruptcy, financial regulation

Dean of the Undergraduate School of Economics and Business Administration and Professor at the Universitat Pompeu Fabra; CEPR Research Fellow

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