“Too Big To Fail”: what is the issue to solve ? Christian LAJOIE 18/10/2010 LSE Financial Markets Group and Deutsche Bank Conference

2 TBTF : a biased expression of the financial system stability concern  Size and business mix are not the issue  Size is protective when it goes with diversification  Variety of activities is a diversification factor  Market share consideration falls under competitive regulations  Capital is not the answer  Current capital requirements would have made up for the losses of the rescued banks  Any surcharge would be useless, unfair and probably counterproductive  Contagion does matter  Resistance to external shocks must be developed by all financial institutions  Contagion must be contained and stopped  Retail investors must be protected  Confidence in the financial system is critical for the economic and social stability  Moral hazard must be reduced to its simplest expression  No free lunch

3 The efficient and fair answer to the financial system stability objective, the prevention component  Independent financial institution resilience  Well managed: Governance, Pillar II, Market  Well capitalized: Basel 3  Enhanced micro and macro supervision: the ESFS  More intensive but focused and expert supervision  Phased and coordinated empowerment of the supervisory bodies  New European supervisory framework: the ESAs (EBA, EIOPA, ESMA)  ESRB  Robust infrastructures  CESR advices on standardization, trading and reporting of OTC derivatives  EC proposal for regulation of OTC derivatives and EU market Infrastructure

4 The efficient and fair answer to the financial system stability objective, the remedy phase (1)  Need for a bifurcated regime  Close to point of default, assessment of the institution’s systemic risk 1.In absence of ripple effect, liquidation 2.Financial system stability in jeopardy, restructuring  In both cases, temporary liquidity provided by Central Banks secured by a first lien  Orderly liquidation  Judicial process or bank’s specific liquidation regime administered by the supervisory body but in line with the bankruptcy law principles  Losses and liquidation costs born by the liquidation proceeds  Any eventual shortage covered by an industry contribution

5 The efficient and fair answer to the financial system stability objective, the remedy phase (2)  Administrative restructuring  Conversion of the subordinated debt into Equity up to the necessary amount to comply with the Core Tier 1 solvency ratio minimum after absorption of losses  Warrant mechanism to restore the claim order in case of total turnaround  Removal of the executive management and appointment of a “resolving body”  Restructuring process in “on-going concern” mode with the view to: Optimize the remaining value of the firm; End with a viable and downsized institution within a reasonable time frame  Challengeable but credible assumptions  Losses do not impair the core Tier 1 solvency ratio minimum  The resolution regime restores market confidence  The orderly liquidation remains a possible option

6 Conversion of subordinated debt into Equity would have absorbed losses and kept the rescued banks technically solvent Minimum Core Tier 1 without Government Support – With and without Tier 1 and Tier 2 instruments conversion in equity RBSAIBCommerzDexiaCitiLloydsINGUBSCS Min Ratio ex. Gov Support 0.5%2.5%2.7%5.4%-2.1%4.0%4.3%6.1%8.6% Min Ratio ex. Gov Support but with T1 & T2 Converted in Equity 5.6%6.7%8.1%8.7%9.2%10.2% 12.5%14.8% Total Reg Initial Cap (A) Government Capital Injected (B) B / A81%24.8%71.5%41.7%33.6%40.3%24.1%13.1%0.0% 2%

7 Bail-in analysis – Key take-away  The financial crisis caused major losses for many financial institutions, leading to the default or drastic restructuring of several banks.  Government capital injections were necessary to shore up depleted capital positions and more importantly to restore confidence in the financial system.  If public capital had not been injected: 1.Only one bank (Citi) would have had a negative Core Tier 1 ratio; AIB is a specific case that cannot be the base for regulating the financial system. 2.Some banks would have seen their capital position eroded to such an extent that their survival would have been at stake due to lack of market confidence.  Assuming that Tier 1 and Tier 2 instruments would have been used to create Core Tier 1 capital, all banks would have maintained their Core Tier 1 ratio above 4% (twice the minimum) without government support.