On the Law and Economics (and the Politics) of Bank Resolution

1. MPI Gemeinschaftsgüter Martin Hellwig On the Law and Economics (and the Politics) of Bank Resolution Gerzensee July 3, 2014

2. Resolution on the Agenda • 2008 experience: No tools for dealing with systemic banks in crisis • No tools for reducing systemic fallout of applying insolvency law • After Lehman Brothers, all bank creditors were bailed out • In „euro crisis“, initially, all creditors were bailed out – Cyprus and SNS Reaal as paradigm changers? • Desire to protect taxpayers

3. New Legislation • UK Banking Act 2009: Special Resolution Regime, run by BoE, requires Treasury approval for any (exceptional) commitment of taxpayer money • US Dodd Frank Act 2010: Expanded Resolution Authority of FDIC, interim funding by Treasury, ultimate funding by industry levy (DI) and clawbacks • German Bank Restructuring Act 2010: Interim funding by government, ultimate funding by industry levy (bank restructuring fund) (who does what is unclear)

4. EU Banking Recovery and Resolution Directive • Special Resolution Authorities in all Member States • Potential recapitalization before entry into resolution regime (subject to state aid control) • Pre-resolution regime („early intervention“) with supervisor-mandated removal/replacement of management and/or supervisor-appointed temporary administrator working with, or replacing management (conditions vague and unclear) • Nothing on interim funding • General principles concerning „bail-in“ tool, funding from govt. only after this tool has been used

5. Euro Area Single Resolution Mechanism • Euro area resolution authority (single-entry for euro area) • Board (Chair, Vice Chair, four permanent members, and relevant national authorities), in charge of adopting a resolution scheme including relevant resolution tools and any use of the Single Resolution Fund. • If the Commission or the Council object to it, the Board would have to amend the resolution scheme.

6. Fundamental Shortcomings • Multiple-entry resolution for banks with systemically important operations in different countries destroys operational procedures (cash management, IT) • College of resolution authorities impractical; • Ditto for procedure under SRM; • Without prior agreements on loss assignments, single-entry resolution will not be agreed upon – ring-fencing in resolution exacerbates the problems.

7. Fundamental Shortcomings • In the EU, interim funding is unclear. • German Ministry of Finance, January 2011: „If we were to wind down HRE, there would be a funding problem and the bank would break down“ Total liabilities at the time: € 320 bn. • Projected Restructuring Fund for SRM: € 55 bn. • In the EU, there is self-deception about ultimate taxpayer liability/fiscal backstop • Restructuring levy has limited capacity, even ex post • Bail-ins?

8. Background • Experiences of the crisis: Lehman Brothers, Northern Rock, Hypo Real Estate, Fortis • Cross-border issues: Lehman Brothers, Fortis • European integration: Commission, ECB and banking union • National resistance: Bank Resolution involves issues of distirbution and power • Lobbies: Banks and investors like weak resolution regimes • Lobbies: Traditional insolvency law specialists

9. Example: Hypo Real Estate • October 2008: Hypo Real Estate in trouble, the government passes a law (FMStG), which allows it to give banks capital and guarantees. HRE gets guarantees; in January 2009, the government puts in new funds and acquires 50% of the equity. • Spring 2009: „Lex HRE“: The government is given the powers to „expropriate“ remaining shareholders; in the summer, a squeeze out takes place (in the shadow of the Lex HRE, outside shareholders get 1.30 EUR per share). • All debt holders are bailed out: Deutsche Bank, Allianz, Established Churches, Public Radio&TV instititutions, many municipalities....

10. The example continued • March 2009: The ministries (Econ, Finance, Justice) begin to work • August 2010: Cabinet decides on a draft Bank Restructuring Law – „to avoid the HRE experience ever being repeated“ • December 2010: … Law is passed • January 2011: „If we were to wind down HRE, there would be a funding problem and the bank would break down“ (Comment by finance ministry on a proposal to wind HRE down in order to reduce excess capacity in the market)

11. Why the 2008 bailout? • Why did shareholders of a bankrupt company that the government had to bail out get anything? • Why were hybrid/junior/senior unsecured bondholders protected? • Fear of systemic repercussions • ... or subsidies to important players?

12. Notes on German Law • Unclear procedures and institutional role assignments • Primary objective of intervention: creditor protection! In the past, this has led to insolvency-like procedures, freezing of assets.... • System protection is only subsidiary objective; Transfer of assets to bridge bank „only if necessary for avoiding systemic risk“ • „systemic risk“ not defined in terms of systemic functions (unlike UK) but in terms of importance of creditors who may need to be protected

13. Shortcomings • Creditor protection versus system protection • A freeze of operations has immediate domino effects • Rapid liquidation of assets depresses markets and increases writedown needs at other institutions • Lack of flexibility • At the time when dangers are recognized, it is not yet clear what will be the best way to proceed, how much of the operation can be or should be saved • It is also not clear what will be the best mode for disposing of assets. • Liability?

14. Systemic Implications of the Lehman Insolvency • Contractual domino effects on Lehman counterparties, e.g. Reserv Primary Money Market Fund holding Lehman paper • Market effects of Lehman unavailability as a (new) counterparty • Information contagion effects on markets: Breakdown of repo markets • Information contagion effects on banks no longer expected to be bailed out • Information contagion on money market funds

15. Systemic Implications of the Lehman Insolvency 2 • Defensive reactions of money market funds: Withdrawals from unaffected banks, e.g. European banks • Defensive reactions of banks: Rush for cash, asset sales • Asset price declines: due to loss of confidence and to fire sale effects • ... feed into further writedowns, causing further reactions.... • Panic

16. Lessons learnt (?) • Banks must be bailed out (lesson learnt by bankers) • We need better resolution regimes for banks or, more generally, systemic financial institutions • Reforms so far have mostly been weak and tentative • And authorities seem unwilling to apply them (West LB was not wound down under the restructuring law)

17. Contagion mechanisms 1 • Contractual Interconnectedness 1: dominos ex post: Lehman Brothers – Reserve Primary • Contractual Interconnectedness 2: Disappearance of contracting opportunities: Lehman Brothers as a market maker, money market fund investors who run, money market funds that no longer provide wholesale short-term lending (repo, ABCP)

18. Contagion mechanisms 2 • Information Contagion: Lehman Brothers not TBTF has implications for other investment banks; Reserve Primary breaking the buck means that other mmmf‘s may not be safe • Hysteria Contagion? Sunspots and equilibrium multiplicity, „hypersensitivity“ to information

19. Contagion mechanisms 3 • Asset price contagion: Fire sales depress asset prices, which leads to writedowns at banks with similar positions and possibly further fire sales by these banks... • Credit crunch contagion: Defensive strategy of one institution leads to a reduction in lending, which forces their borrowers to become defensive as well

20. Issues • Procedural • When to intervene • Who • How to decide which parts of the bank are „good“ and which are „bad“ • How to dispose of the different parts • Substantive • Objectives • Principles • Funding • Legal Issues: Derivatives and Repo

21. Example: Sweden 1992 • Immediate government takeover • Bailout of all debt holders • Full liability of shareholders • New management with new careers to be made • Full transparency about losses • Separation of good and bad banks under control of government-installed managers • Adjustment of market structure

22. The UK Approach • Banking Act 2009 creates a Special Resolution Regime for Banks • Objective: System Protection (defined in functional terms) as well as Creditor Protection • FSA pulls the trigger, BoE takes over • … with a great deal of discretion • … but a clear assignment of responsibility • ... and there is a fiscal backstop

23. Discretion of BoE • Possible Choices of the BoE: • Immediate sale • Transfer to a BoE owned bridge bank • Temporary public ownerhips: transfer of shares to Treasury in return for funds (Treasury approval, takeover) • Restructuring: Bank insolvency procedure, bank administrative procedure • Separation of assets, on particular with a view to protecting markets (netting in derivatives markets)

24. BRRD procedure • Supervisor pulls the trigger • (Can try early intervention before) • Resolution authority takes over • Objective System protection • Has wide discretion: • Sale of business • Bridge institution • Asset separation • Bail-in (only if there is a serious prospect of recovery)

25. BRRD procedure 2 • Valuation at time of resolution • Temporary, to be followed by ex post as soon as possible • Provides the basis for bail-in • Assignment of liability (writedowns or conversions) in the order of the hierarchy of claims under insolvency law • „no creditor worse off principle“

26. Concerns about valuation • Valuation of assets before resolution is problematic • In practice, the bank‘s problems are partly due to the fact that asset values are unclear. • Examples: MBS, Spanish real-estate loans • The BRRD‘s requirement is impractical and likely to give rise to legal disputes • Example: In 1990, estimates of S&L losses in the US were on the order of $ 600-800 bn. In the end, the number was $ 153 bn. • Similar experience in Sweden

27. Good Banks versus Bad • Uncertainty about asset values is at the core of the debate about good banks and bad. • Bad Bank: The existing bank sells bad assets to a government-funded institution and continues in operation; if the price is high, this involves a government subsidy. If the government has a right of clawback, the debt overhang problem of the existing bank is not really solved. • Good bank: A new bank is created and gets the assets and deposits of the old bank. The old bank retains the equity of the „good bank“. Creditors of the old bank share in the risk of the assets.

28. Procedure 2 • Art. 43 suggests that the bail-in tool is applied at the time when the authority steps in. • The article refers to debt instruments being written down or converted into equity. This is done on the basis of the valuation at the time of resolution. How does this relate to write downs/conversions on the basis of valuations ex post? • The bail-in tool is to be applied only if there is a reasonable prospect of recovery. What if the prospect does not materialize, th ebank is liquidated, and ex post values differ greatly from valuations at th etime of resolution? Liability?

29. BRRD Exemptions from Bail-Ins • Statutory exemptions • Covered deposits • Secured liabilities including covered bonds and derivatives (up to value of collateral) • Liabilities to (financial) institutions with an original maturity of less than seven days • Trade credit • Additional exemptions „in exceptional circumstances“ at the discretion of the resolution authority subject to certain conditions (time scale for bail-in, systemic risk, contagion) • Funding by resolution institution/restructuring fund

30. Comments on BRRD Exemptions • Unqualified exemptions for secured liabilities create incentives for asset encumbrance • Unqualified exemptions for short-term funding from other financial institutions create incentives for short-term wholesale money market funding – the Dexia and HRE strategy • Additional exemptions at the discretion of resolution authorities create room for protecting politically favoured creditors – the HRE policy again

31. Resolution Fund Support for Additional Exceptions • Should come in only after a contribution of not less than 8% of total liabilities including own funds has come from equity holders and holders of other eligible instruments • Must not exceed 5 % of total liabilities including own funds • Can be financed from existing resolution fund, new levy (for three years), „alternative financing sources“ • Further funding may be provided beyond the 5% limit, if ALL unsecured liabilities other than deposits have been written down or converted

32. Minimum Requirements for „Own Funds and Eligible Liabilities“ • Can be set by authority (8%?) • Eligible liabilities = any (?) liabilities that are not subject to exemption from bail-in • Subject to bail-in in the form of conversion or write-down • To be contractually specified • ... pre-specified, as in Liikanen, cocos, etc.? • ... Or subject to rules of insolvency law? • Question: Is a standard unsecured 5-year bond an eligible liability? Even if it is old and has no reference to bail-in in the contract?

33. Comments • 8 % „eligible liabilities“ – are we to assume that 92 % is immune from bail-in? • „Bail-in“ is nothing but the simple principle that, if equity is negative, creditors get what is left. • If we accept the view that „bail-in“ is special, we will never get back to a regime where banks‘ creditors take care as to where they put their money. • Treating xyz loans as special invites regulatory arbitrage.

34. Open issues: Cross-Border Resolution • Lehman Brothers: UK authorities found that there was no cash • Multiple-entry resolution destroys organizational integration • Destruction of systemically important operations • Single-entry resolution raises serious issues of distribution of losses – ring-fencing • Living will of Deutsche: US authorities should trust Bafin • Bafin 2012: Unicredit Germany must not provide liquidity support to Unicredit Italy (the parent)

35. Cross Border Resolution in BRRD • In principle a multi-entry approach, but there is a college of resolution authorities • Under the SRM (euro area) there is a single resolution authority, but this is byzantine internally • SRM does not include UK

36. Open issues: Funding • Insolvency law: New lenders get priority old lenders are frozen – this is enough to maintain operations • Not workable for banks: Freezing of old lenders such as depositors or money market funds has strong systemic effects • Moreover, short-term funding is so large that even with priority, it is seriously at risk – see repo runs on Bear Stearns and Lehmans • Exempting secured lending and short-term lending from bail-in does not ensure that short-term funding remains available

37. Funding in BRRD • Issue is not addressed • There seems to be a presumption that after bail-in short-term funding is forthcoming again • No remedy if mmmf‘s flee • ECB as a lender of the last resort? • Lending if there is a solvency risk? • Some member states may allow for loans from Treasury (as Dodd Frank does in US) but this is unclear. • Support from ESM? From Single Restructuring Fund? Numbers are small

38. Open Issues: Backstop • „The industry should pay for itself“ • Restructuring fund (based on industry levy) • Deposit insurance institutions (based on industry levy) • Bail-ins • ESM may lend ... • Imposes risk on taxpayers • Possibly not sufficient

39. Open issues: Exit • Most of the directive assumes that institutions should be led to recovery. • Little about liquidation • ... To be transferred to an insolvency procedure? • What is the relation to insolvency law? • A major problem of the industry is that there is too much capacity, probably too many zombies and no viable/credible/politically accepted exit mechanism • Forbearance/recapitalization as the most likely strategies