Formal vs. Informal Bank Resolution Gerard Hertig (based on work with Luca Enriques and Hideki Kanda) Workshop and Lecture Series in ‘Law & Finance’ Zurich, October 14, 2014

What is Bank ‘Resolution’? Formal procedure to deal with failing = non viable bank Not standard bankruptcy/insolvency procedure – Importance of seamless continuity in activities – Assets + Liabilities are acquired by bidding banks – Possible state guarantee for losses by acquirer Authorities may favor informal resolution – Resolution discretion – No visible loss + other reasons Bank Resolution2

Discretion and Failing Banks Banking authorities need some resolution discretion – Appropriate early intervention, including facilitating acquisition by third party – Timely resolution Problems with discretion – May be inappropriate when there is information asymmetry (failing bank or competitor have better information) – May be inappropriate when authorities are risk averse (depositors, politicians and voters may perceive use of discretion as economically or socially costly) – Facilitates hiding of supervisory mistakes – May result in regulatory capture Bank Resolution3

Dealing with Failing Banks Liquidation – Banking activities are discontinued – Asset value depreciation + depositor unrest Resolution – M&A transaction 1. State-initiated – Administrative – Agency role 2.Market-driven – Civil – Court role 3.State-induced – Shadow – Informal threats and subsidies Bail-in/-out – Banking activities are continued – Contractual or mandatory thresholds Bank Resolution4

Failure Disclosure & Procedure Crisis times : Formal – Failure is generally revealed, but gaps in disclosure – Administrative procedure and bailout dominate Non-crisis times : Informal – Failure is often hidden, especially for smaller banks – Civil procedure sometimes relevant – Shadow resolution dominates Bank Resolution5

The Appeal of Shadow Resolution Variance over time and across banks – In crisis times: especially for larger banks – In non-crisis times: especially for smaller banks Concealing inadequate public response – Overly lenient/relaxed supervision – Delayed resolution intervention Minimizing overreactions – Financial markets – Counterparties and depositors Bank Resolution6

Bank Resolution7

Costs & Benefits of Shadow Resolutions Benefits – Flexible restructurings, limited judicial involvement – Reduce risk of massive deposit withdrawal – Less disruptive than formal resolution or liquidation Costs – Supervisory forbearance (mistakes matter less, leniency offers) – Moral hazard (more risk taking, less monitoring) – Distort competition (better connections matter) – Give formal resolutions a bad name Bank Resolution8

Moving Away from Shadow Resolutions Primary advantages – Eliminating/Minimizing the resolution stigma effect – Reducing political influence and supervisory slack Credibility of switch to formal procedures – Japan has moved away from shadow approach – Europe has new supervisory and resolution bodies – FDIC has established capability post-credit crisis Starting with smaller banks – Larger banks generally too-big-to-fail in bad times – Few cases in good times Bank Resolution9

Fostering Civil & Administrative Resolution Sketching a new approach 1. Providing incentives for private workouts 2. Making administrative resolution attractive 3. Empowering deposit insurers 4. Adjusting substantive rules Private Workouts – ‘First go’ option: Not credible in real world – Enlisting turnaround experts and vulture funds Resolution index Corrective action swaps – Incentivizing acquirers Tax benefits (but not compliance exemptions!) Competition exemptions Bank Resolution10

Administrative Resolution Structural measures – Decoupling supervision and resolution? – Joint teams in the vicinity of prompt corrective action? Redefining viable banks – Capital ratio are not a good indicator – Learning from the Treasury’s 2008 CPP actions Good bank/Bad bank vs Loss indemnification – Time & simplicity considerations – Ex ante vs ex post analysis Bank Resolution11

Capital Ratios and FDIC Resolution Equity RatioFailureCPP #% Cum.#% >=15%143.66% % >=10% %24.35% %38.50% >8% %62.04% %77.60% >5% %93.72% %98.91% >4%123.14%96.86%40.48%99.39% >3%71.83%98.69%40.48%99.88% <3%51.31%100.00%10.12%100.00% Leverage RatioFailureCPP #% Cum.#% >=15%71.83% % >=10% %18.06% %15.50% >8% %56.81% %60.29% >5% %95.03% %99.76% >4%82.09%97.12%10.12%99.88% >3%51.31%98.43%00.00%99.88% <3%61.57%100.00%10.12%100.00% Tier 1 RatioFailureCPP #% Cum.#% >=15%246.28% % >=10% %42.93% %54.72% >8% %85.60% %96.61% >5%348.90%94.50%273.27%99.88% >4%143.66%98.17%00.00%99.88% >3%41.05%99.21%00.00%99.88% <3%30.79%100.00%10.12%100.00% Bank Resolution

Allocating CPP Funds to Non-Viable Banks Failure within Failure within Failure within #%#%#% No CPP/No Failure % % % CPP % % % Failed % % % CPP & Failed % % % Total 6900 Bank Resolution

Deposit Insurers Contributing to resolution becoming palatable 100% coverage for retail customers Differentiated approach for other customers – Smaller clients vs larger clients – Enlisting professional investors Competing for insurance business – Minimum premium – Deductibles Bearing some loss indemnification costs Bank Resolution14

Substantive Rules Important for resolution efficiency Example: Rules on priority  impact on: – Players’ incentives – Choice of approach/procedure – Resolution speed – Perceived fairness and politics Bank Resolution15