BANK RECOVERY AND RESOLUTION NZ AND THE EU COMPARED

1. BANK RECOVERY AND RESOLUTIONNZ AND THE EU COMPARED David G Mayes University of Auckland

2. THE CONCERN Both NZ and the EU have decided that in the light of the GFC that it must be legally (and practically?) possible to recapitalise failing banks by ‘bailing in’ their creditors. While there are many similarities between the two approaches, there are important differences, which give a good opportunity for mutual lessons.

3. THE POINT The concern is to deal with severe problems in banks, both before insolvency ‘recovery plans’ and in insolvency ‘resolution plans’ in a way that both causes minimum harm to the real economy and financial stability in general and assigns the losses in a fair manner across those who have knowingly taken the risk

4. THE CONTEXT 4 main changes in regulation of banks since the GFC an increase in capital and liquidity requirements through Basel III; a major reform in the ability to resolve problem banks and other financial institutions, particularly outside the US; a reorganisation of the structure of supervision to make it more comprehensive and effective; and a review of the appropriate structure of financial institutions to make them both less risky and more readily resolvable. A significant reversal of the trend

5. KNOWN PROBLEMS ILLUSTRATED BY THE GFC Too Big To Fail US lex specialis worked for even large banks Systemic risk exception invoked for Wachovia TARP general recapitalisation ended the problem Allowing Lehmans to fail was a disaster Elsewhere bailouts were expected and occurred (RBS, Lloyds-HBOS, Fortis…) Too Big to Save Iceland Cross-border resolution is too difficult

6. RESOLVABILITY Functions vital to financial stability need to keep operating without a break National authorities decide what those are Mainly retail banking in large banks, payment/settlement system, perhaps market making Bank structure and regulatory structure have to make this possible Separate out vital functions from rest of group? Each vital function in each jurisdiction must be resolvable

7. 2 OBVIOUS SOLUTIONS Home country deals with the group as a whole (single point of entry) This may involving saving the group or just the vital functions UK Banking Act 2009 can compel residual bank (in insolvency) to provide services for continuing ‘good’ bank Practical and legal separation (multiple point of entry) The NZ solution – each jurisdiction can solve its own systemic problems Hybrids difficult but this is the EU route

8. MINIMISING DIRECT COSTS Choice of methods (in rough order of cost) Raising new capital either from the existing shareholders or by a new issue on the market Finding a buyer who takes over the functions that need to be continued Obtaining guarantees that will stand in lieu of actual capital Getting a capital injection from the government or some other outside agency – bailing out Writing down the liabilities (bailing in) Performing a debt for equity swap – bailing in Restructuring the organization so that the banking part that needs to saved remains solvent and keeping the losses in a part the goes into insolvency

9. TOOLS Transfer assets and liabilities to other providers Separation into ‘good’ and ‘bad’ banks Bail in – write down or convert liabilities to equity Temporary government control – bridge bank Nationalisation and bail out

10. MINIMISING DIRECT COSTS But vital functions of SIFIs have to be kept operating to avoid contagion and crisis In the past this meant bailing out Now it is to mean bailing in Implies a departure from simple minimisation of costs to the creditors

11. PRINCIPLES Insolvency rules followed for priority and equal treatment (losses first on shareholders then sub-debt, junior unsecured …) No creditor worse off than under insolvency Who pays instead? Taxpayer, bank stakeholders through resolution fund …

12. WIDER COSTS Economic costs (in terms of GDP) Fiscal costs (to the taxpayer) Costs to creditors Costs to bank stakeholders through deposit insurance and resolution funds Costs to banks Moral hazard Costs of avoidance and early action Some costs accrue without a failure, some are contingent, some can be assessed

13. STRUCTURES Designed for handling failure rather than running the business efficiently? Compulsory restructuring Volcker rule (Dodd-Frank Act) Vickers and Liikanen restructuring – latter is still only at the proposal stage Risky activities excluded Living wills/funeral plans Bank proposes, supervisors decide Can they ever be plausible? Need continuing revision

14. THE NZ SCHEME Open Bank Resolution Favourable structure – 4 main banks all Australian owned all primarily retail operations + Kiwibank Local incorporation, practical independence (outsourcing policy) RBNZ supervisor Statutory management (lex specialis) Bail in overnight through writing down on summary conservative valuation – recapitalised later on sale to private sector Requires major pre-positioning

15. WILL IT WORK? Technically possible But no deposit insurance in NZ so ordinary depositors are likely to be bailed in Politically unlikely as too many electors lose Will make system much more unstable as depositors will run at first sign of trouble Deposit insurance buys time for authorities to organise a smooth resolution Probably not loss minimising But Australians will save the group anyway reputation risk? Just remove domestic depositor preference?

16. BANK RECOVERY AND RESOLUTION DIRECTIVE Part of ‘banking union’ Capital Requirements Directive + harmonisation Whole EU/EEA Single Supervisory Mechanism Led by ECB but only covers banks and only euro area plus others who choose to join – not UK Only top 150 banks supervised direct, remainder by national supervisors Beginning with Asset Quality Review to ensure all banks well capitalised no legacy issues

17. BANK RECOVERY AND RESOLUTION DIRECTIVE BRRD All EU/EEA members must have tools, resolution authority and must cooperate, e.g. through resolution colleges SSM countries have Single Resolution Mechanism Board to lead Adds a Single Resolution Fund, built up over 8 years, funded by banks (i.e. their stakeholders) – 1% of covered deposits – is in addition to deposit insurance funds

18. THE PICTURE FOR RRD Ordering of losses – shareholders then creditors in order of priority No creditor worse off than in insolvency Uninterrupted access to deposits and payments transactions Minimise cost to taxpayers Return to adequate capitalisation Important difference from OBR Resolution funds – to bear costs not normally borne by creditors?

19. RESOLUTION FUNDS NOT AVAILABLE TILL ‘losses totalling not less than 8% of total liabilities including own funds have already been bailed in, and the funding provided by the resolution fund is limited to the lower of 5% of total liabilities including own funds or the means available to the resolution fund and the amount that can be raised through ex post contributions within a period of three years.’ (48a)

20. WHO PAYS FOR RESOLUTION FUNDS? Depends on how the banks try to absorb contributions Reduced dividends Higher charges Greater spreads Lower costs Costs borne by those dealing with banks but not especially the troubled bank so incentive weaker

21. BAIL IN VERSUS BAIL OUT Point of bailing in or out is avoid a systemic crisis or to limit the impact substantially Gain from new measures in European Commission Impact study comes mainly from bail in – little from increasing capital requirements Costs occur all the time benefits only when a crisis is avoided (difficult to judge) or when it is resolved at lower cost

22. BAIL IN VERSUS BAIL OUT Cumulative impact (DGS deposit guarantee scheme, RF resolution fund)

23. IMPACT OF OBR

24. GAIN FROM OBR IS INCENTIVE

25. KEY INGREDIENTS OBR not less costly than bailout or resolution without bail in. Gain from reduction in moral hazard and use of cheaper resolution methods – market solution Incentive to behave more prudently and act early before public sector takes over Model unstated and estimates fairly heroic While cost to economy and fiscal cost go down Cost to banks goes up Cost to banks occurs even without failure

26. BAIL IN VERSUS BAIL OUT If not sure whether bail in will happen, moral hazard remains and less gain Ambiguity not constructive? Impact of bail out spread widely over people and time so lessens immediate impact – future taxpayers can absorb cost Bail in has more than 100% impact with conservative valuation Very important whether those bailed in can absorb cost Pension and hedge funds yes – depositors no

27. PROBLEMS Single vs multiple point of entry UK/US feel saving the group is the only certain route in a crisis EU banking union Single Resolution Mechanism, pre-supposes Single Supervisory Mechanism led by ECB Single Resolution Fund gets round conflict of interest and SSM get round problem of blame Debt for equity bail in – 8% before SRF (max 5%) If systemic parts (especially parent) are outside SRM or outside EU then relies on coordination through resolution college Single point of entry cannot handle Too Big to Save

28. PROBLEMS Are those bailed in suitable owners of the bank? For both CoCos and compulsory bail in new equity holders may try to sell immediately causing capital to fall. NZ OBR statutory manager searches for suitable purchaser (auction as in US?) Will other creditors try to trigger bail in to look after themselves? Resolution plans have to ensure enough bailinable debt. What happens if there isn’t?

29. BAIL OUT VS BAIL IN A good bail out makes a profit for the taxpayer Probability of bail in will alter structure of liabilities – pressure for seniority and collateralisation Will put more onus on depositors May require bail out of deposit insurance Time consistency problem for credibility Small bail out preferable to concentrated bail in Will bail in be politically possible – not in NZ?

30. CONCLUSIONS Major increase in intervention and restriction of the activities of banks Debt for equity swaps may transform insolvency and limit ability of existing shareholders to maintain control of the company (no Chapter 11 equivalent) State still likely to end up owning banks, especially where cross-border resolution complicated EU banking union may be a general way forward especially harmonisation of tools – hopefully we never find out

31. CONCLUDING REMARK Main gain from bail in is that it encourages greater prudence and cheaper market solutions Cross-border issues still to be resolved fully Will harm credibility and increase moral hazard Before SRM in place, encourage single point of entry resolution by home country of group or clear division into resolvable subsidiaries as in NZ? Does not deal with ‘Too Big to Save’ Resolvability is the key and that is only a perception ex ante

32. SOME ISSUES NOT COVERED Early intervention/recovery plans Voluntary bail ins – CoCos – trigger points Do they encourage instability? Will it spill over to other banks?