Crisis Management and Resolution

Sergio Lugaresi, Public Affairs

Milan, 15 November, 2012

AGENDA

The issue: taxpayers’ money

Endogenous systemic risk

Liquidation and bail-outs

Essential bank functions

From bail-out to bail-in

2

The main issue: crisis management and resolution

In Toronto (2010) the G20 Leaders identified the third pillar of financial reform in

“resolution and addressing systemic institutions. We are committed to design and implement a system where we have the powers and tools to restructure or resolve all types of financial institutions in crisis, without taxpayers ultimately bearing the burden, and adopted principles that will guide implementation.”

This need international coordination, legal expertise, trust among authorities.

Crisis management

Bankruptcy: Lehman Brothers, New Century Financial, CIT e al. Liquidation with government financing: General Motor, Chrysler Receivership: IndyMac, Washington Mutual Government blessed/guaranted/financed M&As: LTCM (1998), CountryWide Financial,

Bear Sterns, Dresdner, Merrill Lynch, HBOS, Wachovia Split along national lines and bailed-out by governments: Dexia, Fortis Bail-out (guarantees, loans, capital): Northern Rock, West LB, IKB, Commerzbank, AIG,

Fannie Mae, Freddie Mac, JP Morgan, Bank of America, Citigroup. Loyds, RBS, ING

Haphazard, lack of transparency, taxpayers’ money

Bailouts’ political legitimacy has been damaged

Moral hazard: public aids to the financial sector in percentage of GDP (June 2007–June 2009)

5

Countries

Guarantees Recapitalisation Troubled asset purchase

Total

Euro Area 15.8 1.9 1.1 18.7

Japan - 0.0 0.0 0.0

Switzerland - 1.1 7.9 8.9

United Kingdom 10.9 2.2 38.9 52.0

United States 2.2 3.2 3.6 9.0

Systemic risk

Endogenous: Idiosyncratic crises may propagate through contagion and be amplified by interconnection and so generate a systemic crisis

Exogenous: systemic risks generated by macro-imbalances and unexpected events

6

Endogenous systemic risk

= The risk that individual firms’ failure will result in a socially unacceptable impact on the broader economy”

Systemic risk is NOT contagion per se Creditor substitutability? Competition policy Information (good/bad)? Transparency

Socially unacceptable is the contagion to certain creditor categories (savers, employees, national creditors) or “bystanders” (e.g. through the stop of the payment system or the collapse of market confidence)

The resolution of failed business is an inherently distributional exercise (losses)

Socially unacceptable: it is a political rather than an economic matter

When the distribution of losses through liquidation preset rules is socially unacceptable then there is a bail-out. Not only banks (Chrysler, auto industry in Sweden, etc.)

The cross-border dimension add complexity: the decision of one country may have effects on other countries’ creditors.

Liquidation and bail-out

Liquidation: compulsory rules to distribute assets according to preset priorities: this means that some creditors will bear some losses (“haircut” on their assets). This affect LGDs.

Priorities in liquidation are an ex ante political decision (Rawlsian)

Bail-out: haphazard management of a failed company with government support without preset rules. Creditors do not take losses unless there is an agreement.

Bail-out inconveniences: Taxpayers’ money Political decision Moral hazard (no LDG)

However, in presence of systemic risk the choice between liquidation and bailouts is illusory

To address systemic risk

Prevention: Macro-prudential supervision (European Systemic Risk Board and US Financial Service

Oversight Council) countercyclical buffers (Basel 3) Recovery and Resolution Plan Additional capital requirements for SIBs Firewall and ring fencing (Volker, Vickers, Liikanen) National ring-fencing

Systemic risk can be mitigated but not eliminated Therefore, what to do ex post?

Bank specific resolution issues

Usually, general insolvency procedures for non-financial companies allow stakeholders adequate time to reach an agreement which, if necessary, may include an amount of public support. In any case, when sufficient time is available, an agreement is easier to reach and there is less risk to revert to an inefficient liquidation.

However, three factors distinguish bank-specific proceedings from general corporate insolvencies.

1. Banks’ liabilities are essentially short-term and highly liquid. Bank creditors cannot accept a long, drawn-out resolution process to wait for their claims.

2. Banks’ essential functions (such as payment systems) cannot be disrupted.

3. The number of bank creditors makes coordination and reaching a rapid insolvency agreement extremely difficult. Thus, bank insolvencies require speed yet lack a swift procedure to reach a creditor agreement.

Crisis management and resolution: essential bank functions

For the FSB, authorities should have the tools to intervene “to ensure the continued performance of the firm’s essential financial and economic functions, including uninterrupted access of depositors to their funds wherever they are located” and avoiding “panic or destabilization of financial markets”.

In its proposal on crisis management and resolution the European Commission included also “large bank lending activities” among the essential financial functions whose performance authorities should be able to ensure. This makes sense particularly with reference to the activities linked to the payment system and to the supply of working capital, particularly to small and medium size enterprises.

Crisis management and resolution: ex ante effects

Rules to orderly resolve SIFIs, but not only…: They have effects on PD and LGD and therefore on lending decisions Market confidence: definitive loss allocation is required to cut off uncertainty

Ex ante regulatory role

From bail-out to bail-in

To re-legitimise bail-out: De-politicisation of decision: a Resolution Authority To reduce moral-hazard and minimise taxpayers’ money:

Separation of essential functions from “bad assets” hair-cut imposed by the Authority

Issues: Who is taking over the bad assets? The principle of “no creditors worse-off” (par conditio creditorum or pari passu) limits

the hair cut to the estimated “normal” LGD. Removing the moral hazard increase the cost of debt. If the PD is higher than

its “normal” value” (i.e. the bail-in occurs before insolvency) and is not compensated by a certain equal reduction in the LDG, the cost of debt may be higher than its “normal” level.

Will the bail-in LGD restore market confidence? The hair cut is effective in protecting “bystanders”, but not necessarily enough to

protect critical creditors How to distribute losses among different jurisdictions?

The EU proposal

Resolution tools should include forced sales of business activities, a temporary bridge bank and an asset separation tool.

Resolution powers should include: the power to transfer shares, assets, rights or liabilities; the power to impose a temporary moratorium on the payments of claims; but also the power to write down debt or convert it into equity (bail-in).

National resolution authorities should be established

Hair-cuts on a large set of debt instruments (except one-month)

Implicit burden-sharing criteria (art. 92)

The EU proposal: issues

Issues: Only for banks: sectoral disparities No European Resolution Authority In Italy bank bonds held by households are savings Minimum bail-inable capital requirement No delayed hair cut

How will it work?

The Resolution Authority will decide if the failure of a company has a systemic risk (SIBs are included ex ante)

In case, the Authority will tentatively assess the losses (during the week-end…) If there are no private purchaser and the Authority assess that it is unable to split the

company between a good one and a bad one… …on the basis of this assessment the Authority will decide the hair-cut on non

collateralised and non-insured creditors. The critical function will not be discontinued (access to deposits, payment system)

The Authority will intervene to bail-out critical creditors.

References

Levitin, Adam J., “In Defence of Bailouts”, Georgetown Law Journal, 2011.

17

Next

Th. 11 Oct. h 10.30-12.15, aula 3

1. Introduction. Cross-border banking and regulation Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari

2. Prudential Regulation: Lessons from the Crisis Fri. 26 Oct. h 10.30-12.15 aula 3

3. From Basel 2 to Basel 3 Thu. 8 Nov. h 10.30-12.15 aula 3

4. Moral hazard Thu. 15 Nov. h 10.30-12.15 aula 3

5. Crisis Management and Resolution Thu. 22 Nov. h 10.30-12.15 aula 3

6. Shadow Banking Thu. 29 Nov. h 10.30-12.15 aula 3

7. Rules and supervision Thu. 6 Dec. h 10.30-12.15 aula 3

8. Overall assessment of the regulatory reform Thu.13 Dec. h 14.30-16.30 aula 20

9. The Euro debt crisis and the Banking Union Mon.17 Dec. 10.30-12.15 aula seminari

10. Wrap-up and conclusion

18