Here's Another Plan For Not Bailing Out Too Big To Fail Banks

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Some analysts at the Bank for International Settlements have found a new way to unwind too-big-to-fail banks painlessly, which I guess is newsworthy; here is a good summary, and here is the actual paper. The basic idea is to resolve a bank over the weekend by writing down its debt by some regulator-chosen amount X, giving it X more capital, which is held by a new temporary holding company. Then the bank reopens for business on Monday with more equity and less debt. The holding company eventually sells its equity in the bank to the market, and distributes the proceeds "to [the old bank's] creditors and shareholders strictly according to the hierarchy of their claim." Here are some blue boxes:

The main attraction of this, besides speed, is that it provides a market mechanism for determining how much senior creditors lose: regulators decide how much of the bank's senior liabilities are converted into holdco liabilities, but those holdco liabilities retain their seniority over subordinated liabilities and equity, and ultimately the amount of writedowns suffered by the senior (and junior for that matter) debtholders depends on how much the bank's equity is ultimately worth when the holdco sells it.

It's neat! There are some issues. One is picking the initial writedown. The authors say:

The resolution authority will determine the proportion of senior liabilities written off. Their determination must be based on a generous estimate of the amount of equity that must be created if the bank is to sustain the full range of potential losses that it may still be expected to incur. That is, the authorities need to give both themselves and market participants comfort that the bank will remain sufficiently well capitalised as actual losses materialise. As explained later, the authorities can make a generous estimate because the size of the write-off does not determine the ultimate losses suffered by creditors.

The estimate has to be generous, because "If the market still doesn’t think the bank has positive value after the recap, you have a problem." But it can't be too generous, because "It’s certainly easy to see how a regulator would shy away from making a bold initial call on the necessary write-downs if they feared sending a negative signal regarding other, similar banks in their jurisdiction." So you still have the potential for bureaucratic equivocating and alternatives-seeking.

Second is deciding how long the holdco hangs out trying to make its money back. The paper says only "The temporary holding company is required to sell the bank in the months following its recapitalisation." How many months? Selling the bag of stuff that made up AIG paid off the senior debt and also returned $22 billion profit to the government, but took like five years. But the government was in total control and had a pretty pretty low cost of capital. You could imagine the creditor-owned holdco of a failed bank having the characteristics of, like, a squirming bag of angry cats, some of whom want to sell quick and cut their losses, others of whom want to hang around and see if asset prices recover. You'd need a governance mechanism and someone to referee it.

Third is ... I mean if you squint this is "bankruptcy but faster": you keep your essential businesses in place, you just haircut (by shifting into a parallel universe of holdco) some funding. But the bank's business consists mostly of being funded. Saying "we'll snip all senior claims the same" is nice in blue boxes, but some of those senior claims are, like, undercollateralized derivatives claims.1 Snipping those could make the Monday reopening difficult.2

Other senior claims are bank deposits, which technically but not otherwise are pari passu with any other senior debt. The BIS paper is refreshingly straightforward about these: deposits get haircut just the same as any other senior debt, and insured depositors get made whole by the deposit insurance fund. The insurance fund then gets a claim on the new holdco, pari passu with other haircut senior debt:

However, rather than writing off a portion of insured deposits to create equity, the deposit insurance scheme (DIS) is required to make a payment of equal
size to the bank in lieu of this amount. Insured depositors are therefore completely unaffected by the write-off. However, along with other senior claimants, the DIS is given the most senior securities issued by the holding company. The DIS holds an amount of these securities equal to the portion of insured deposits of the bank which would have otherwise been written off.

So everyone, even the FDIC or equivalent, gets treated the same, according to legal seniority rather than according business or political or other imperatives to favor some senior creditors over others. Maybe that'll work? But to trust it you really have to believe that, in an actual crisis with competing demands from various classes of senior debt holders, regulators will respect the pre-existing rules and the technical seniority of claims rather than trying to monkey with the process to save/hose some favored/disfavored class of creditors. Some people are betting on that. But in recent history it's been more the exception than the rule.

A template for recapitalising too-big-to-fail banks [BIS]
Recap recap [DEM]
Has BIS Found the Solution to Too Big to Fail? [WSJ / RTE]

1.Ponder what "undercollateralized" means over the weekend when you're recapitalizing the bank. Hi, you have a derivative claim for $100 as of Friday's close, and $99 of collateral. Monday morning your derivative claim jumps to $105. How much collateral do you have Monday afternoon? How much of your derivative claim still exists? How much is poofed into a senior claim on the holdco? Etc.

2.The BIS plan has important differences from the single-point-of-entry/living-will style resolution plans of big US banks, but also important similarities. Both seem a bit sanguine about chopping senior creditors.

Related

Banks Prove That They Are Not Too Big To Fail By Saying "We Can Fail" On A Piece Of Paper, Moving On

One way you could spend this slow week is reading the "living wills" submitted by a bunch of banks telling regulators how to wind them up if they go under. Don't, though: they're about the most boring and least informative things imaginable and I am angry that I read them.* Here for instance is how JPMorgan would wind itself up if left to its own devices**: (1) It would just file for bankruptcy and stiff its non-deposit creditors (at the holding company and then, if necessary, at the bank). (2) If after stiffing its non-deposit creditors it didn't have enough money to pay its depositors it would sell its highly attractive businesses in a competitive sale to willing buyers who would pay top dollar. This seems wrong, no? And not just in the sense of "in my opinion that would be sort of difficult, what with people freaking out about JPMorgan going bankrupt and its highly attractive businesses having landing it in, um, bankruptcy." It's wrong in the sense that it's the opposite of having a plan for dealing with banks being "too big to fail": it's premised on an assumption that the bank is not too big to fail. If JPMorgan runs into trouble that it can't get out of without taxpayer support, it'll just file for bankruptcy like anybody else. Depositors will be repaid (if they're under FDIC limits); non-depositor creditors will be screwed just like they would be on a failure of Second Community Bank of Kenosha.