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“Too Big To Fail”: what is the issue to solve ?

“Too Big To Fail”: what is the issue to solve ?. LSE Financial Markets Group and Deutsche Bank Conference. Christian LAJOIE 18/10/2010. TBTF : a biased expression of the financial system stability concern. Size and business mix are not the issue

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“Too Big To Fail”: what is the issue to solve ?

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

  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 • In absence of ripple effect, liquidation • 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 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: • 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. • 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.

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