Deposit Insurance Reform and the Need for a Special Bank Insolvency Regime

1. Deposit Insurance Reform and the Need for a Special Bank Insolvency Regime George G. Kaufman (Loyola University Chicago) London School of Economics January 30, 2008

2. Why Need Reform? • Current system of preventing bank failures and resolving them is frequently inefficient, uncertain, and excessively costly

3. Basic Purpose of Current Deposit Insurance Systems • Stop bank runs by insured parties by eliminating threat of credit losses (if credible) • Limit bank fire-sale losses from runs and threat of “technical” insolvency • Limit contagion

4. Problems with Current Deposit Insurance • Two potential losses in bank failures • Credit losses (PV-RV; K < 0) • Liquidity Losses (limited access / freezing due to delayed sales) • Shifts not eliminates depositor credit losses • Does not address customer liquidity losses • Encourages bank moral hazard risk-taking • Greater portfolio risk • Lower capital • Encourages regulatory forbearance • Funding not withdrawn, bank can stay open • Thus, increases probability and cost of bank insolvencies in long run

5. Solution to Deposit Insurance Problem • Eliminate not shift credit losses • Eliminate not neglect liquidity losses • Focus on prompt legal closure at low but positive capital (no credit loss) and prompt customer access to accounts (no liquidity loss) • Make deposit insurance redundant (but not unnecessary) • Need special bank bankruptcy regime in most countries

6. Four-Point Efficient Bank Insolvency Resolution Program(Eisenbeis-Kaufman) • PCA to prevent insolvencies, but with prompt legal closure at K > 0 (minimize credit losses) • Prompt estimation and allocation of credit losses to uninsured claimants (enhance market discipline) • Prompt sale/bridging of insolvent bank (minimize liquidity losses) • Pay insured depositors par • Pay uninsured depositors advance dividends of estimated recovery amounts • Provide performing loan customers access to credit lines 4. Prompt reprivatization at above minimum capital

7. Four-Step Program Requires • Fund or borrowing authority by insurer to make payments to depositors before final sale • Credible PCA framework to minimize bank insolvencies and buy time for appropriate regulatory actions • Prompt and efficient bank bankruptcy regime

8. Keep Deposit Insurance on Retail Deposits • Redundancy / back up • Get small depositors off the street and at home / political

9. Prompt and Efficient Bank Bankruptcy Regime • Banks “special” / different • Even brief interruption of many activities, e.g. deposit and credit access, payments clearing / settlement, can have major adverse externality • Avoiding adverse externalities trumps resurrecting bank as firm • Prompt legal closure (minimize credit loss) and continuity of service with certainty (minimize liquidity loss) prime import • Corporate bankruptcy regime generally cannot provide above results – not prompt, not efficient, not certain

10. Case for Bank Regime:U.S. Bank and Corporate Bankruptcy Codes

11. Case for Bank Regime:U.S. Bank and Corporate Bankruptcy Codes

12. Case for Bank Regime:U.S. Bank and Corporate Bankruptcy Codes

13. Why Review Past Problems and Make Case for Reform? • Optimist – Avoid repeating errors George Santayana (1863-1952) “Those who cannot remember the past are condemned to repeat it” • Pessimist – Most do remember the past George Kaufman (alive) “Those who can remember the past will agonize first and then repeat it”

14. Thank you