Financial Crises
Chapter

Chapter 16. The Economics of Bank Restructuring Understanding the Options

Author(s):
Stijn Claessens, Ayhan Kose, Luc Laeven, and Fabian Valencia
Published Date:
February 2014
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Author(s)
Augustin Landier and Kenichi Ueda The authors are deeply indebted to Olivier Blanchard and Stijn Claessens for numerous discussions. They would also like to thank Ricardo Caballero, Giovanni Dell’Ariccia, Takeo Hoshi, Takatoshi Ito, Nobuhiro Kiyotaki, Thomas Philippon, Philipp Schnabl, and many colleagues at the IMF for their helpful comments.

What is the best policy option for rescuing a troubled systemically important bank? Various plans have been proposed, some of which have already been implemented around the world. Examples include capital injections in the form of equity or hybrid securities (such as convertible debt or preferred shares), asset purchases, and temporary nationalizations. However, the various restructuring options are rarely evaluated and compared with each other based on a coherent theoretical framework. This chapter develops such a framework.1

Claims often heard in the public debate can be clarified and evaluated using this framework. Should bad assets be sold off before a bank is recapitalized? Should hybrid securities, such as preferred stock or convertible debt, be used rather than common stock in recapitalizations? Is it possible to restructure a bank balance sheet without resorting to a bankruptcy procedure and without involving public money? Is it better when taxpayers participate in a rescue plan to benefit from upside risk?

This chapter makes three main points:

  • In principle, restructuring can be done without taxpayer contributions.

  • If debt contracts cannot be renegotiated, taxpayer transfers are needed, but some schemes are more expensive than others.

  • Once the relevant market imperfections are taken into account, restructuring is likely to require actions on both the liability and the asset sides.

The goal of restructuring is assumed to be to lower the probability of the bank’s default with minimal taxpayer burden. The analysis starts with a simple frictionless benchmark, following Modigliani and Miller (1958). It then excludes the possibility of debt renegotiation. This approach illuminates a key conflict between shareholders and debt holders. Later, more realistic assumptions, for example, the costs of financial distress and asymmetric information, are introduced.

In the frictionless framework, debt contracts can be renegotiated easily and the default probability of a bank can be lowered by transforming some debt into equity (debt-for-equity swap). This restructuring preserves the financial value of both debt and equity. Therefore, there is no need for public involvement to decrease the probability of default. In practice, however, restructuring is often difficult because of the speed of events, the dispersion of debt holders, and the potential systemic impact.

When debt contracts cannot be renegotiated, taxpayer transfers are necessary for a restructuring plan to be carried out. The debt holders see the value of their claim go up, thanks to a lower default probability. Absent government transfers, their gain equals the loss in equity value; shareholders would therefore oppose the restructuring.

Transfers vary depending on the plan. The level of transfers reflects the extent to which debt holders benefit from the restructuring. Most options are equivalent to a simple recapitalization in which the bank receives a subsidy conditional on the issuance of common equity. The transfer can be reduced if the proceeds of new issues are used to buy back debt. Restructuring involving asset sales turns out to require more transfers than does recapitalization.

Next the chapter examines how to design restructuring outside the Modigliani and Miller framework. Specifically, cases are examined in which restructuring can bring economic gains; for example, the bank can gain new customers who were previously apprehensive. The potential for private surplus can facilitate restructurings and reduce taxpayer cost. In maximizing the total surplus (i.e., private surplus and social benefits), both the pros and the cons of key strategies emerge. The restructuring plan should include contingent transfers so that a bank manager has an incentive to try to make the bank profitable. Up-front transfers should be minimized to prevent misuse of taxpayer money. Separating bad assets from a bank helps managers focus on standard bank management and can therefore increase productivity. Some assets may be underpriced compared with their fundamental value as a result of lack of liquidity and deep-pocket investors. In such cases, it may be optimal for the government to buy them. However, because the government often lacks the necessary expertise, it is advisable to use private experts to run an asset management fund or a nationalized bank. Finally, from a long-term perspective, managers and shareholders should be sufficiently penalized to prevent future financial crises.

The chapter also investigates the role of asymmetric information—when banks know more about their assets than the public does. In that case, banks are more reluctant to participate in a restructuring plan, so they would demand additional taxpayer transfers for their participation. This is because participating banks may be perceived by the market to have more toxic assets and to need more of a capital buffer. Such negative market perception induces a lower market valuation and higher financing costs. The use of hybrid instruments, such as convertible bonds or preferred shares, mitigates the problem because it does not signal that the issuer is in a dire situation. Asset guarantees turn out to be even more advantageous. To eliminate participation-related transfers, a compulsory program, if feasible, is best. In addition, the government should gather accurate information on underlying assets through rigorous bank examination and use it in designing restructuring options.

In summary, the best course for government is to combine several restructuring options to solve the multifaceted problem. On the one hand, rescue plans determine how the surplus from restructuring is shared among debt holders, equity holders, and taxpayers. On the other hand, the surplus from the restructuring itself varies depending on the plans because different plans change the behavior of the various parties. The best overall strategy involves both asset- and liability-side interventions.

The chapter proceeds as follows. The first section introduces the benchmark Modigliani-Miller framework. The second section assumes no scope for debt renegotiation and compares several restructuring options under a fixed restructuring surplus to achieve the target default probability of a bank. The third section examines, under various frictions, how the restructuring design affects the surplus. The fourth section discusses the willingness of banks to participate in a plan when asset quality is known only by bank managers. The fifth section analyzes other considerations, namely, political constraints and a worst-case scenario in which bankruptcy is inevitable. The penultimate section reports case studies for Switzerland, the United Kingdom, and the United States, and is followed by a conclusion.

A Benchmark Frictionless Framework

The exercise begins by analyzing the restructuring of a bank in a simple framework in the spirit of Modigliani and Miller (1958), and shows that the bank can decrease its probability of default to any target level by converting some debt into equity. A restructuring can be carried out in such a way that neither equity holders nor debt holders are financially worse off.

Setup

A bank manages an asset A currently (time 0), which will have a final value A1 next period (time 1). The final value A1 is stochastic. It is drawn from a cumulative distribution function F. The capital structure at time 0 is debt with face value D, which needs to be repaid at time 1. Equity has book value E (see Figure 16.1, panel a). Absent restructuring, the probability of default of the bank at time 1, p, is the probability that the next-period value A1 will be less than the debt obligation D, that is, p = F(D) (see Figure 16.1, panel b).

Figure 16.1A Frictionless Framework

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probablility; A1 = final asset value; D = debt; E = equity; p = probability of default; p* = target probability of default.

The assumptions of Modigliani-Miller are that markets are complete and efficient, without any information frictions. Under these assumptions, the sum of the market values of debt and equity is independent of the bank’s capital structure and equals the market value of the asset: V(A) = V(E) + V(D) (see Figure 16.1, panel c). This chapter also assumes D < V(A), implying that the bank is not currently insolvent, but it does assume a positive default probability.2 The market value of debt V(D) is thus smaller than the book value D.

Assuming large social costs associated with default of a systemically important bank, the government’s objective can be stated as lowering the default probability or, in practice, achieving a target default probability p* = F(A*).3 A bank-restructuring problem amounts to finding a way to achieve p = p* starting from a higher default probability, p > p*.

First Best: Voluntary Debt Restructuring

The government’s objective is to decrease the probability of default p while making no one financially worse off. This objective is feasible by a change in the structure of claims, namely, the partial transformation of debt into equity. More specifically, a restructuring that leaves both debt and equity holders indifferent is the conversion of debt D into a combination of lower-face-value debt (D' = A*) and an additional piece of equity with value V(D) – V(D'). This is a partial debt-for-equity swap. The new financial stake of the initial debt holders is worth V(D') + (V(D) – V(D')), which is by design unchanged from the original market value of debt V(D). The bank’s future cash flows are unchanged; only the sharing rule for these cash flows has changed, so the total value of the bank is unchanged (following the Modigliani-Miller theorem). Because the value of the claims that belong to the initial debt holders is unchanged, the value of the equity of the initial shareholders remains the same as well.

Figure 16.2 illustrates the change in the liability structure induced by this partial debt-for-equity swap that makes the probability of default equal to p*. The total payment promised to debt holders decreases from D to A*. This is illustrated by the downward shift of the horizontal line for debt payoff in Figure 16.2. After the restructuring, a fraction of the equity is given to the initial debt holders to compensate them for the decrease in the value of debt. Thus, when the bank does not default, equity accounts for a larger fraction of the asset’s payoffs. Graphically, the equity line shifts up. The full conversion of debt into equity against a fraction of equity would also be a solution to the restructuring problem. Either scheme can be implemented by means of a debt-for-equity swap.4

Figure 16.2Debt-for-Equity Swap

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt.

Restructuring with no Debt Renegotiation

Although the proposed debt-for-equity swap is the first-best solution, it is often a difficult solution to implement in practice. A major reason is the speed of events, which leaves no time for negotiation. The possibility of a deposit run calls for quick resolution, while the dispersion of bank debt holders requires a lengthy negotiation process. An orderly bankruptcy might be the most efficient way to structure the renegotiation process, but might negatively affect other systemically important institutions. The discussion below assumes that the government wants to avoid such a bankruptcy procedure because of the potential systemic costs.

With no renegotiation of debt contracts and no help from the government, a restructuring that reduces the probability of default increases the value of the debt and thus decreases the value of the equity. Therefore, it will be opposed by shareholders and a restructuring will not happen unless the government provides subsidies in some form or makes participation compulsory. This section examines various possible restructuring options that do not involve renegotiation of the debt contracts. It also assumes that transactions with external parties other than the government are carried out at a fair price (i.e., reflecting expected discounted cash flows) and that markets are efficient. This means that, for these external parties, financial transactions must be zero net present value projects.

Many schemes are equivalent, though not all—some imply a higher recovery rate for debt in case of default than others. Asset sales, for example, are more expensive than subsidies to the issuance of common equity. The optimal scheme is a form of partial insurance on the asset’s payoff. Changing the liability side by subsidized debt buyback is an option close to the optimal scheme.

Difficulty of Voluntary Restructuring

Without debt renegotiation and in the absence of transfers from the government, all restructuring that lowers the default probability p would be opposed by equity holders because such restructuring increases the value of debt at the expense of equity (the debt overhang problem; Myers, 1977). Debt holders are better off in every possible scenario—the default probability of a bank becomes lower and the recovery rate in the event of default becomes higher. The value of debt thus increases from V(D) to V' (D) and, without third-party involvement, the increase in debt value is precisely compensated for by a decrease in equity value, V' (E) – V(E) = –(V' (D) – V(D)) < 0. The worse shape the bank is in initially, the larger V(D) – V' (D) and the larger the loss imposed on shareholders. Shareholders of more distressed banks thus tend to be more reluctant to restructure.

Shareholders need to be either forced or induced in some way through government subsidies to approve such restructuring. Their approval is needed because they have control rights as long as the bank does not default. The transfer needed from the government is equal to the increase in the value of debt, T = V' (D) – V(D). This transfer equals the expected discounted value of immediate and future payoffs from the government. Under this transfer, the value of equity remains unchanged. How this transfer varies across different restructuring schemes is now examined in detail.

Government Subsidy and Debt Recovery

All restructuring schemes that achieve a target default probability p* must involve a subsidy from the government. The size of this subsidy determines the debt’s degree of safety. From this perspective, among the schemes examined, asset sales appear to be the most costly for taxpayers. Whatever the final realization of A, asset sales result in the largest increase in debt recovery and therefore the largest transfer to debt holders. Figure 16.3 gives a preview of the results, illustrating the debt recovery schedule for various realizations of A1 and various types of restructuring. Restructuring shifts the default threshold to the left (from D to A*) and changes the payoff to the debt holders in case of default D < A*. This new recovery schedule can vary depending on the restructuring plan (three different slopes in Figure 16.3). Restructuring that creates higher recovery schedules is more costly to taxpayers because it (indirectly) transfers more value to debt holders.

Figure 16.3Restructuring and Debt Recovery

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt.

State-Contingent Insurance: Optimal Subsidy

The restructuring scheme that minimizes the transfer from taxpayers is described first. The size of the transfer can be expressed graphically as a function of the asset’s realization A1 (Figure 16.4, panel a). Figure 16.4, panel b, shows the corresponding debt recovery. Because the objective is to decrease the probability of default, improving the recovery of debt in case of default is not needed. Graphically, default occurs in the left part of the figure, A1 < A*. The government should make no transfer in this region (Figure 16.4, panel a). This leaves debt recovery unchanged from the prerestructuring situation (Figure 16.4, panel b). When the realized asset value A1 is between A* and D, the bank needs a transfer D – A1 from the government so that it is able to repay D to debt holders and avoid default. When the realized A1 is above D, no subsidy is needed to avoid default. In other words, the optimal restructuring is a guarantee under which the government transfers money ex post only when the bank is in default but not far from solvency. This scheme would not provide any transfer to debt holders when default is inevitable (A1< A*) or when the bank can repay debt on its own (A1> D).5

Figure 16.4Minimizing the Transfer from Taxpayers

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt.

The relative cost to taxpayers of various types of restructuring depends on how close the schemes are to implementing this optimal debt-recovery schedule. The optimal scheme might be difficult to implement and calibrate in practice, but it provides three useful insights. First, to decrease the probability of default, the government does not have to subsidize the recovery rate for all the realized value of the assets. It should instead focus on avoiding default only when the bank is close to solvency. Second, it is not necessarily a bad deal that the taxpayers do not receive any upside or even any positive cash flow in exchange for their intervention. Some of the rescue schemes examined below occasionally provide payments to taxpayers. However, the optimal scheme never provides any payments to taxpayers, but its overall cost to taxpayers is the lowest. Third, more transfers could boost the share price, but a higher share price does not mean a good rescue plan from the point of view of taxpayers.

Recapitalization with Common Equity

One straightforward way of decreasing the default probability is to issue new equity and keep the proceeds as cash, which makes the debt less risky. Bankruptcy occurs then with prob(A1+ Cash < D), equivalently, prob(A1< D – Cash) or F(D – Cash). The minimum amount of cash that has to be raised is such that p* = F(D – Cash), that is, Cash = D – A*. This is shown as the intercept of the debt-recovery schedule in Figure 16.5. For a given realization of asset value A1 that forces the bank into default (A1< A*), the debt holders can recover cash in addition to the remaining assets, D – A* + A1.

Figure 16.5Recapitalization

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt.

Because default occurs less often and the recovery rate is higher, the value of debt increases from V(D) to V' (D). The new equity holders do not make or lose money by investing (efficient markets). Assuming no government subsidy, the gain of debt holders V' (D) – V(D) is obtained at the expense of the old equity holders, who will lose exactly that amount. This implies that the equity holders would oppose the restructuring. Issuance of equity is dilutive for preexisting shareholders, not because an equally large pie is now divided among more shareholders—in fact, the pie is bigger because of the proceeds of the new equity issue—but because the debt holders receive more of the pie.

To make the restructuring acceptable to shareholders, the value of the equity should not decrease. To this end, a possible policy option is for the government to give the bank cash in the amount of V' (D) – V(D) conditional on the bank’s issuance of equity of an amount D – A* – (V' (D) – V(D)) at a fair price reflecting the expected discounted value of future payouts to shareholders. With the total new cash D – A*, the probability of default becomes p*. The market value of the debt jumps by V' (D) –V(D) and the government loses exactly that amount, so that, as planned, shareholder value is unchanged (see Figure 16.5).

Recapitalization by Issuing Preferred Stock or Convertible Debt

Instead of issuing equity, banks could issue hybrid securities such as convertible debt or preferred stock.6 This would not change the analysis of the previous section. In these cases, the debt-recovery schedule of initial debt holders is the same as in Figure 16.5, implying that the restructuring’s impact on preexisting debt value, V' (D) – V(D), and thus the transfer of the taxpayer, is the same as in a recapitalization through the issuance of equity.

To show that the recovery of preexisting debt is the same as in Figure 16.5, two cases are considered separately. In the first case, the new claims do not trigger default. This case applies to preferred stock or convertible debt with a conversion option at the issuer’s discretion, given that the dividends do not have to be paid out (preferred stock) or the debt converted into equity (convertible debt) when the bank is unable to pay dividends or coupons. In this case, the capital that needs to be raised to achieve the target default probability p = p*, and thus the recovery schedule of initial debt, remains the same as in the case of recapitalization with common equity. The second case involves the issuance of convertible debt, with the conversion not determined by the issuer (i.e., the conversion is automatic or at the holder’s discretion) and seniority equal to that of preexisting debt.7 The recovery rate is in proportion to total debt (pari passu)—so the slope of the recovery is the same as in the equity issue case (see Figure 16.6, panel a). At the same time, the trigger point for defaults after restructuring is set to be A* as in the equity issuance case. Thus, the recovery of preexisting debt is exactly the same as in the equity issuance case.8

Figure 16.6Issuance of Convertible Securities

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt; D' = debt after restructuring. Modigliani and Miller (1958) indicate that Cash = V(New claim) in panel b.

To make equity holders willing to accept the restructuring, the government has to compensate them with a conditional transfer identical to the one needed for an equity issuance. Total wealth before and after the restructuring remains the same (conservation of value). That is, the sum of the changes in wealth of initial equity holders, initial debt holders, new claim holders, and taxpayers is zero. Because new claims are issued at a fair price, the new claimholders’ wealth is unchanged. Provided the restructuring needs to leave initial equity holders’ wealth unchanged, the taxpayer transfer should be equal to the change in debt value. This is the same as in an equity issue.

Subsidized Debt Buybacks

When equity or other securities are issued, banks do not have to keep the proceeds on their balance sheets and might as well use them to buy back some debt. This decreases the taxpayer transfers required to implement p = p*. The bondholders that sell to the bank are not assumed to be naive—they know that the value of the debt will rise as a result of the restructuring and therefore agree to sell only at the fair price that reflects the postrestructuring value of their claim.9 The fraction α of outstanding debt that needs to be bought is such that (1 − α) D = A*, and the remaining debt contracts are untouched, so the new aggregate face value of the debt is (1 – α) D = A*. After the announcement, the value of the initial debt should increase from V(D) to V' (D), reflecting the lower default probability after the restructuring. Out of this initial debt, a fraction a is bought back by the bank at a value α V' (D), while a fraction (1 – α) remains outstanding, with market value (1 – α) V' (D).

To leave the equity holders indifferent, the government needs to subsidize the buyback. In exchange for the transfer, the bank should be willing to issue equity to buy back a fraction α of the debt. Equivalently, the government can directly buy debt at the postrestructuring market price and convert it into equity at a conversion rate that leaves equity holders indifferent.10 As in the other schemes, the optimal size of the government transfer is equal to the increase in debt holders’ wealth created by the restructuring, V'(D)–V(D). Regardless of whether they keep their bonds or sell them, all initial debt holders receive this gain on a pro rata basis. The remaining debt is a fraction (1 – α) of the initial debt. The gains of the remaining debt holders are (1 – α) of the gains of all the initial debt holders. Thus, the transfer by the government can be calculated by rescaling the realized recovery of the remaining debt by a factor 1/(1 – α) (the upper line in Figure 16.7). This total implied recovery reflects the restructuring effects on the full initial debt.

Figure 16.7Debt Buyback

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt; α = fraction of debt bought by bank by issuing new equity.

This scheme is less costly for taxpayers than a recapitalization in which cash from new issues is kept on the balance sheet. Indeed, this scheme’s recovery schedule (upper line of Figure 16.7) is lower than the recovery schedule of the recapitalization in Figure 16.5. Economic intuition suggests that buying back debt and converting it into equity is closer to the first-best solution (i.e., debt-for-equity swap agreed to by debt holders). Altering the liability structure decreases the size of the transfer required from the government (Bulow and Klemperer, 2009).

Simple Asset Guarantees

An alternative way to decrease the default probability to p* is for the government to offer full or partial insurance on the bank’s assets using simple asset guarantees. To limit the cost to the taxpayers, such insurance can have a cap (partial insurance). For instance, to reach a default probability p*, the government can insure against the value of assets falling below D, with a maximum transfer of DA*. This guarantees that the bank will be able to repay its debt fully as long as A1 > A*. In contrast to the optimal scheme, however, this transfer will be paid even in the worst cases, A1 < A* (see Figure 16.8).

Figure 16.8Transfer under Capped Asset Guarantee

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; D = debt.

This scheme leaves the equity value unchanged from the prerestructuring situation (all transfers benefit debt holders) and has exactly the same cost for the government as a recapitalization that involves subsidizing new securities issues (equity or hybrids). This outcome occurs because the implied debt recovery is identical to that in Figure 16.5. Compared with the optimal partial insurance scheme discussed previously, this plan is more costly because it makes debt recovery higher in a default. A full insurance scheme (without the transfer cap) would cost taxpayers more because it would involve higher payments in the worst cases, A1 < A*.

It is always optimal for taxpayers to insure total assets as opposed to a specific subset of them (e.g., mortgage-related debt only). Future payoffs of a subset of assets do not perfectly predict the default of the bank as a whole. Thus, higher transfers (as a precautionary cushion) are necessary to achieve the same default probability.

Caballero’s Scheme

Ricardo Caballero (2009) proposes the following: If the bank issues new equity in the amount of D – A* to private investors, the government provides a loss guarantee for the new equity owners by promising to buy back the new equity at a fixed price in the future. That is, the government distributes free put options to the new equity holders. The floor price can be set by backward induction. Specifically, the government transfer should be set to equal the gains of debt holders, V' (D) – V(D). This makes the current equity holders willing to adopt this scheme because it leaves their wealth unchanged.

With regard to transfer by the government, Caballero’s scheme is equivalent to the subsidized recapitalization with common equity (Figure 16.5) because it implements the same debt recovery schedule, D – A* + A1. It differs from the subsidized equity issues in that it requires no up-front transfer by the government.

Above-Market-Price Asset Sales

Another alternative is to sell a fraction a of the assets to the government at an overvalued price with markup m, that is, (1 + m) a V(A), to achieve the target default probability p = p* without dilution for shareholders.11 The proceeds of the sale are again assumed to be kept as cash on the balance sheet. It turns out that the government transfer needed for these asset sales is larger than for all the mechanisms considered so far.

To see this, note that the new assets owned by the bank are cash and remaining old assets, (1 + m) a V(A) + (1 – a) A, which have higher expected value and lower risk than the original assets A (see Figure 16.9, panel a). Because default occurs less often than in the do-nothing case, the value of the debt increases by V' (D) – V(D). This jump is larger than in the case of recapitalization with common equity, with the same default probability p*, because the recovery rate for every realization A1 is larger.12 This is illustrated by a simple graph showing that the slope of the recovery schedule in the default zone is now (1 – a) instead of 1 (see Figure 16.9, panel b). It is irrelevant whether the government or private investors hold the assets, as long as the government subsidizes the price by a markup m so that it provides the subsidy required to compensate equity holders.

Figure 16.9Above-Market-Price Asset Sales

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; A1 = final asset value; a = fraction of assets bought by government at an overvalued price; D = debt; E = equity; m = markup on assets.

Sachs’s Proposal

Sachs’s (2009) proposal is a variant of asset sales. Instead of using a market price, Sachs proposes to sell a fraction of assets at book value to the government to avoid immediate write-downs, but with a condition that requires the bank to pay the government’s losses when the assets are sold off later (recourse condition). Sachs proposes to use newly issued equity to compensate the government for the later losses. More specifically, the government would hold warrants entitling it to receive common stock equal in value to the eventual loss from the sale of the assets. The current equity holders would bear the costs through the dilution.

This plan includes a hidden subsidy from the government to debt holders. The probability of default is indeed now lower and the recovery rate higher. The government does not recover anything unless all debt has been repaid, because the value of the equity is zero in a default. However, equity holders become worse off under this plan. On the one hand, if the asset value turns out to be lower than the book value, equity holders face the same payoff as in the do-nothing case—the government receives the difference between the book value and the realized value. On the other hand, if the asset value turns out to be higher than the book value, the initial equity holders receive only the initial book value. Therefore, the impact of the plan on the value of the equity is negative: equity holders would oppose it.

Combining Several Schemes

A bank-restructuring plan can be designed by combining multiple schemes, such as asset sales with recapitalization. As long as banks have to participate in all schemes or none, the overall transfer matters, but not the origin of the transfer. For example, a higher asset sales price can be compensated for by a lower subsidy to new equity issues. However, if banks can choose to participate in some schemes but not others, subsidies must be chosen optimally on a scheme-by-scheme basis rather than as a whole.

Private and Social Surplus from Restructuring

The future cash flows of a bank can be thought of as a pie shared between shareholders and debt holders. Restructuring can increase the size of this pie. To this end, the government needs to pay attention to the various stakeholders’ payoffs and incentives. For example, decreasing the probability of default might attract customers who were previously worried about the bank’s high probability of failure. This potential private surplus can facilitate restructuring and reduce or even eliminate the need for transfers from taxpayers. Contrary to the clear-cut picture that emerges from the previous section, an optimal restructuring plan is no longer easily identified. Actual plans may need to combine features of various schemes considered so far. For example, relying exclusively on asset guarantees might diminish managerial incentives to optimize ex post asset payoffs, but relying exclusively on ex ante cash injections might create opportunities for managers to increase their own private benefits.

Key Concepts

Costs of Financial Distress

A high probability of default is widely recognized to reduce a firm’s total value (the value of equity plus liabilities). A bank is in financial distress when this decrease in value becomes economically significant. The exposition will associate financial distress with a probability of default p > p*. A small fraction of the costs of financial distress is composed of the direct, ex post costs of bankruptcy (e.g., legal fees), but a large fraction is composed of indirect, ex ante costs. For example, depositors, interbank market counterparties, and employees tend to avoid a bank close to bankruptcy. Managerial attention might be diverted to keeping the company afloat rather than managing the business. In addition, some positive-value projects, such as new lending opportunities, may not be undertaken by a financially distressed bank,13 which reduces the total value of the firm (debt overhang).14 All in all, lowering the default probability of a bank (from p to p*) can create some extra value, called the private restructuring surplus.

A parsimonious way to introduce the potential gains from restructuring is to assume that when the probability of default is higher than p*, the ex post payoff of assets becomes less than its potential by an amount C.15 The restructuring is then a positive-sum game over the surplus C to be shared between debt and equity holders. It is difficult to quantify this surplus for a bank, but the corporate finance literature estimates that for a typical nonfinancial company the costs of financial distress are about 10 percent to 23 percent of ex post firm value (Andrade and Kaplan, 1998). The surplus can be generated if the default probability becomes less than p*. Because there is a private surplus (C) to share, the incentives to find an agreement through renegotiation are higher than in the frictionless case.

Social Benefits and Government Participation

Restructuring a systemically important bank is likely to bring aggregate economic gains, in particular when it is near collapse.16 The magnitude of the social benefit B determines the upper limit of government’s willingness to pay for a restructuring plan. The social benefit depends on how much other banks are affected by the bank’s failure (putting the functioning of the payment system at risk) and on how unexpected the default event is.17

Allowing for government intervention, restructuring a bank becomes a positive-sum game in which the total surplus S = C + B is shared among three parties: equity holders, debt holders, and government. There can be three cases:

  • If the private restructuring surplus for a bank is more than the improvement in debt value caused by the restructuring, C > V' (D) – V(D), government intervention is not needed. The government should resist attempts by the other stakeholders to extract a subsidy.

  • If government intervention is needed, the government is willing to pay a transfer T as long as the aggregate benefit is bigger than this transfer, B > T. The minimum cost for the government to achieve p = p* is V' (D) – V(D) – C, that is, the change in debt value net of the private surplus created by the restructuring.

  • If the social benefits are small, B < V' (D) – V(D) – C, the aggregate surplus is still positive but too small to leave the debt contract unchanged and make both equity and the government better off. In this case, the government needs to organize renegotiation of the debt contract to reach a mutually beneficial restructuring.

Endogenous Surplus and Restructuring Design

Neither the private nor the social surplus created by decreasing the bank’s default probability are purely exogenously given, but are affected by the design of the restructuring plan. Among the various schemes that achieve the target default probability p = p*, those that maximize the restructuring surplus B + C are the most efficient—they will minimize the transfer required from taxpayers—and thus should be pursued.18 Several relevant frictions are analyzed below, such as the allocation of talent and managerial incentives. These frictions should be taken into account when designing a restructuring plan.

Allocation of Talent

Span of control and attention. To increase bank managers’ productivity, it may be useful to remove toxic assets from a bank, either through asset sales or by splitting a bank into a “good” bank and a “bad” bank. Removing distressed assets from the managers’ span of control allows them to focus their attention on typical bank operations, without spending much time on bad-asset management, which other specialists, such as vulture-fund managers and bankruptcy lawyers, can handle with more expertise.

Expertise. Managerial decisions should be in the hands of agents equipped with the appropriate level of expertise and experience. This concern is particularly relevant when public control is involved in a restructuring. The mechanisms through which managers are appointed and monitored should be carefully designed when the government inherits some control rights. This principle should apply to both banks and asset management companies. In other words, bank restructuring, particularly asset sales, should involve some form of public-private partnership. One way to select managers in a transparent and efficient way (i.e., without leaving them excessive rents) is to auction off the management contracts to a predetermined group of professional investors who meet certain standards of quality.

Moral Hazard (Hidden Actions)

Free cash flow (looting of subsidies). Injecting public money up front, before the assets’ payoffs are realized, may offer bank managers an unnecessary opportunity to use public money for their private benefit, such as larger bonuses and perks. In addition, shareholders may demand more dividend payments. To reduce this problem, government should try to use ex post rather than ex ante transfers. For example, asset guarantees are immune to this ex ante looting possibility because they do not provide managers and shareholders with an opportunity to misuse public money.

Incentives to run a restructured bank. Bank managers should be given incentives to maximize the final payoff A1. For example, asset guarantees may reduce managerial incentives to maximize the assets’ payoffs A1 as well as shareholders’ incentives to monitor managers. The implications of this concern are thus the opposite of the previous one. The optimal solution depends on the relative importance of both frictions. A reverse problem occurs in Sachs’s (2009) proposal, in which assets are bought at face value by the government and banks commit to pay the losses ex post—a full guarantee by banks about ex post payoffs might provide poor incentives to the government or the manager of the asset management company to maximize asset liquidation values.

Concerns about the Future

Positive medium-term effects of convertibles. A restructuring plan should be evaluated not only for its effect on the following period but on subsequent periods as well. The plan can minimize the costs of financial distress in the future by including a plan of action if the bank’s outlook were to deteriorate further. In particular, adding a convertible feature to new debt-like claims enhances surplus because it can be seen as an automatic restructuring plan for future periods. Suppose, for example, that a bank raises capital in the initial period through convertible debt, but that the default probability in the future turns out to be higher than expected. In this case, the bank (the issuer) would convert the convertible debt to common equity, thereby reducing the default probability in the future (Stein, 1992).

Long-term impact. To prevent future crises, it is important to recognize the long-term effect of a restructuring plan. The moral hazard problem inherent in too-big-to-fail institutions is increased if the punishment received by managers and equity holders (and then bondholders) was small and transfers from taxpayers were large.

Undervaluation Resulting from Limits of Arbitrage

So far the analysis has assumed efficient markets, such that market valuation V(A) always coincides with the fundamental value of assets, J(A) (i.e., the discounted value of future cash flows). However, the market does not always price assets at their fundamental value. Undervaluation of assets does not necessarily stem from irrational behavior of market participants. It can result from a lack of deep-pocket arbitrageurs. The price of an asset depends on liquidity constraints of market participants and can drop following negative shocks to the liquidity available for funding. Because the government is less constrained, such limits of arbitrage in the market may create a situation in which the market price of the asset V(A) is lower than the pricing by the government VGOV(A). The difference in pricing creates a motive to trade between market participants and the government. The surplus from restructuring a bank should include this arbitrage gain to the government, VGOV(A) – V(A).

If they are indeed undervalued in the market, toxic assets might be bought by the government above the market price but below their fundamental value, with a net gain from the point of view of the taxpayers. The arbitrage gains are largest if the government purchases the most-underpriced assets from banks. The arbitrage gains of the government are smaller if its claims on the banks or on the vehicles holding toxic assets are more debt-like than equity-like. A debt claim’s payoff is capped, and therefore does not vary with the underlying asset’s final payoff when it is large. By contrast, an equity claim’s final payoff keeps increasing with the underlying asset’s payoff, allowing the arbitrage to be large. This is also the case for a highly distressed debt instrument that behaves like equity. If the government relies on private investors to purchase toxic assets from banks at their fundamental value, the government may use a part of the potential arbitrage gains VGOV(A) – V(A) as an incentive for private managers to ensure their participation.

When computing the fundamental value of an asset, the same cost of capital should be applied, whether by a private market participant or by the government. It is not the cost at which debt can be issued by the entity but the cost that reflects the risks of the specific asset. In the current context, both the government and market participants should value a bank at the same fundamental value J(A)—the sum of future profits discounted by the risk premium associated with assets, but without including a liquidity premium associated with the financing constraints of a specific entity. The arbitrage gains, if any, exist because the market participants cannot purchase at this fundamental value as a result of funding-liquidity constraints, not because the fundamental value for the government is different from the fundamental value for the market participants (the cost-of-capital fallacy).

Participation Issues Under Asymmetric Information

When the asset quality of banks is unknown to market participants but known to managers, participation in a restructuring plan tends to signal negative information about asset quality. This makes banks reluctant to participate in a plan unless persuaded by a high subsidy. This reluctance comes in addition to the reluctance induced by the debt-overhang problem analyzed previously. The additional subsidy required to overcome the signaling problem can be reduced if the plan uses asset guarantees or hybrid securities rather than equity issues. A compulsory program, if feasible, reduces the taxpayer burden. Rigorous bank examination can also mitigate the problem if the results can be communicated credibly to market participants.

Recapitalization with Asymmetric Information on across-Bank Asset Quality

In the presence of asymmetric information, managers have private information on the fundamental quality of their assets J(A).19 The market values the bank’s assets at the average quality V(A). If private information could credibly be made public, high-quality banks would be valued above market value. Otherwise, the information gap remains.

Voluntary Participation

The analysis now turns to inducing banks to participate in a recapitalization plan. Assume there are two types of banks: one with high-quality assets and the other with low-quality assets. The focus is on the case in which even banks with high-quality assets need restructuring. The probabilities of default of low-quality banks (pL) and high-quality banks (pH) are both higher than the threshold level, pL > pH > p*.20 The goal of the government is to make sure that both types of systemically important banks achieve the (same) target level of default probability p* while minimizing taxpayer transfers to those banks.

When banks participate voluntarily in a restructuring plan that involves claims issued to private investors, managers of high-quality banks demand high subsidies from the government because the high-quality bank cannot signal their true value. Thus, when issuing new financial claims on assets based on market perception, existing shareholders would bear an unfair burden: Because new claim holders would price the new claims below their fundamental value, the issue would take place at a discount, at the expense of existing shareholders. This discount must be compensated for in the transfers the government provides.

Without a high subsidy, high-quality banks would opt out of the plan. Given this behavior by high-quality banks, even low-quality banks would not participate in the plan. If they participated, their identity would be revealed and their assets would be valued at their true, low level J(AL). This would further increase the cost of their financial distress.21

Therefore, the government needs to pay a high subsidy to induce all banks to participate in the plan. As a result, low-quality banks would be oversubsidized, benefiting from an informational rent. At the same time, high-quality banks would end up overrecapitalized by the plan because they would receive the same treatment as the low-quality banks.22

Role of Hybrid Securities

To induce voluntary participation in a plan involving the issuance of new equity, the subsidy from taxpayers would have to be high—the information gap between the fundamental value and the market value of the equity is large for a high-quality bank. Debt would be an ideal claim to issue, because the gap is small as a result of its flat payoff shape.23 Unfortunately, issuing debt is not useful given that the goal of restructuring is to decrease the default probability. However, hybrid debt-like claims can be used to decrease taxpayer costs because their value is less sensitive to private information than is the value of equity. In addition, hybrid securities such as convertible notes, subordinated debt, and preferred shares can be counted, at least partially, as regulatory capital.

  • Convertible notes can be seen as essentially “backdoor equity” if the exercise of the conversion option is mandatory or at the discretion of the holder. Convertible notes are a way to issue equity while reducing the information-based cost of equity issues. For a specified period (typically, a few to several years), convertible notes have the payoffs of a debt contract and can be converted after that at the discretion of the holder into a specified number of equity shares. Figure 16.10 illustrates the final payoff of a convertible note, with conversion at time 1 at the holder’s discretion. Notations are identical to those in the section titled “Restructuring with No Debt Renegotiation,” but the payoff is shown for one unit of the convertible note with a normalized face value of one. The converted equity value of the security is depicted on the right side of the figure. The slope of this part of the payoff line is proportional to the conversion ratio (i.e., the number of shares each convertible note becomes).

Figure 16.10Convertible Note

Source: Authors’ illustration.

Note: A* = asset value that achieves target default probability; D = debt.

Unlike the issuance of additional debt, issuing convertibles allows the probability of default to decrease because the cash raised by issuing the convertible is the value of the debt portion plus the equity portion of the convertibles’ future payoffs. If the equity portion is large enough, the amount of cash raised is larger than the promised debt payment D, so the issue decreases the probability of default. The choice of the conversion ratio needs to solve a trade-off: on the one hand, the higher the conversion ratio, the lower the probability of default, because more cash is raised initially; on the other hand, when the conversion ratio is lower, the payoff is flatter overall and therefore less sensitive to information on the final payoff. In line with theory, stock market reactions to convertible issues are typically much less negative than for equity issues. If the conversion is automatic after a certain time, rather than left to the discretion of the holder, the equity feature of the convertible is stronger (everything else equal). Thus the signaling cost is higher.24

  • Preferred shares essentially work as a credit line: payments are fixed but can be skipped, in which case they accumulate at a certain rate. This type of claim is clearly less information sensitive than equity is (because payments are fixed) but more sensitive than debt is (the firm can skip payments when in distress). Therefore, the costs to initial shareholders of the bank issuing preferred shares should be lower than for its issuing common equity. Note that features of preferred shares and convertibles (or any hybrids) can be combined in practice.

Optimality of Asset Guarantees or State-Contingent Transfers

The cost of asymmetric information can be mitigated if the government proposes transfers that do not involve the issuance of new securities and that are contingent on the realization of asset values. From the point of view of asymmetric information frictions, among the restructurings considered so far, asset guarantees, either the optimal partial insurance scheme or the second-best capped transfer contingent on default, appear to dominate all restructuring plans involving the issuance of a claim on the assets. If a plan does not ask anything from banks in return, every bank will participate in the plan (no signaling). The government should compute A* using the payoff distribution of the low-quality bank. By doing so, it overinsures the high-quality banks as in recapitalization cases (they will have a default probability lower than p*), but there is no need to overtransfer to low-quality banks, unlike under recapitalization cases in which the low-quality banks benefit from an informational rent (subsidy to compensate for the stigma of issuing equity).

Compulsory Programs

The costs associated with asymmetric information stem from the need to ensure that banks voluntarily participate when participation is regarded as a bad signal about the quality of a bank’s assets. However, the government does not need to use a voluntary program. Rather, it can use a compulsory program targeting a specific set of banks (e.g., mandatory equity issuance as proposed by Rajan, 2008; and Diamond and others, 2008). By doing so, the government can largely mitigate the asymmetric information problem. A compulsory program, however, may need specific changes in the legislation and might not be feasible when systemic risk is imminent.

Asset Sales with within-Bank Adverse Selection (“Lemons” Problem)

Some bank assets are of higher quality than others, and managers have private information on their quality. If given the opportunity, banks will sell lower-quality assets. The government should factor in this behavior and pay only the price that reflects the anticipated quality of assets, which could be determined by an auction mechanism (Ausubel and Cramton, 2008).

Balance sheet externalities. The price of sold assets determines the book value of bank assets (under mark-to-market accounting) and therefore the compliance of banks with regulatory solvency ratios. If government purchases an asset at the price of low-quality assets, it may force a bank into regulatory insolvency because this bank (as well as all other banks) needs to book all assets at this price. A consequence would be that all banks will write down equity or set limits on asset growth (i.e., credit crunch). This effect in turn may justify subsidized sales prices. However, this argument has no economic motive other than regulatory constraint because rational market participants are aware that banks sell their worst assets.25

Correlation between the amount of toxic assets and overall asset quality. If a bank sells more toxic assets to the government than the average bank, market participants will infer that the bank’s asset quality is below average.26 The bank might then be reluctant to participate in the plan as a result of the negative signal.

Use of Government Information

Bank examination. If the government obtains more accurate information about bank assets from a rigorous examination (e.g., a stress test), the government can reduce the cost of any restructuring plan by disclosing the results to inform investors.

Asset guarantee. Asset guarantees without caps on transfers put taxpayers at risk and thus can work as a credible signal that the government is confident about the downside risk of assets. In contrast, a public statement without such a commitment would not be a credible signal. In turn, asset guarantees can convince investors to invest in the bank at a price that may not be dilutive for existing shareholders.

Caballero’s scheme and commitment on future policy. Insurance on the stock price of a bank, as in Caballero’s (2009) proposal, is another way to send a credible signal about government’s confidence in the asset quality of a bank as well as future policies of the government. For example, by guaranteeing the stock price, nationalization with high dilution of shareholder value becomes a more costly option for the government. The higher cost can expunge a possible time-inconsistency problem of the government on ex post nationalization of the bank. This, in turn, can make equity more valuable.

Other Considerations

Political Constraints

Opportunity cost for the government. If the government has limited overall resources, it should take into account the restrictions that the restructuring scheme puts on other investments. In addition, given political pressures and fiscal rules, the cost of mobilizing liquid resources immediately may be high (see discussions in Johnson and Kwak, 2009). In this case, preference might be given to mechanisms such as asset insurance or Caballero’s scheme (insurance on new stock issues), which involve only ex post transfers. However, a credible plan for honoring these transfers should be in place.

Political influence on management. If government continues to be a major shareholder for a long period, a general problem for state-owned enterprises would emerge. Voting-rights holders are supposed to monitor management, but the government is not equipped for this function. Mismanagement would be likely to occur often because government lacks expertise and might be subject to political pressures concerning the bank’s lending policy. This would discourage the bank from participating in a restructuring plan, if voluntary. Recapitalization using hybrid instruments, without voting rights, would be less likely to induce this type of mismanagement. If there is little chance of selling public stakes quickly, one way to avoid the inefficiency resulting from public control is to have government hold common equity without voting rights. However, with a large disparity between control rights and cash flow rights, another type of mismanagement may arise. For example, other shareholders might use their de facto control power to misuse the bank’s profits at the expense of the taxpayers (tunneling). In addition, even without voting rights, government (or parliament) could influence—at least partially—managerial decisions if a bank participates in any government-led restructuring plan.

If Bankruptcy Is Inevitable

If the realized asset value is less than the threshold level (A1 < A*), the optimal response of government may be to let the bank go bankrupt—A* should be chosen that way ex ante by weighing the trade-off between benefits and costs. In particular, if the bank is under heavy liquidity pressure in the market or from depositors, other options may not be readily available. Still, government should make the bankruptcy less destructive. For a typical distressed firm, private equity funds or rival firms would take over immediately. However, there is often little time for those types of investors to conduct due diligence for a bank, partly because banks are highly leveraged and may collapse before the due diligence is completed. Moreover, bank assets are much more opaque compared with the assets of firms in other industries, so due diligence requires more time, likely a half year or more.

To carry out an orderly resolution, temporary nationalization is inevitable.27 This strategy essentially mimics a private solution for a severely distressed firm in other industries (e.g., by a vulture fund). By holding a large share of common equity, government can control the bank’s management. In particular, the government can acquire all the necessary information to assess asset values and liquidity conditions more accurately and quickly. As the majority owner, government is in a strong position to ask debt holders and other stakeholders to share the burden. As a consequence, government can limit the taxpayers’ burden, expedite the resolution process, and sell the bank to private investors.

If temporary nationalization is unavoidable, further discussion is needed about the scope of debt to be honored, in addition to deposits covered under deposit insurance or any other instruments covered under various insurance schemes. Even without any prearrangement, to save the payment system—at least in the short term—transaction-purpose instruments, for example, interbank market borrowings, should be honored. There is less justification for honoring long-term debt. However, further discussion is needed on other transaction-purpose instruments, such as bank guarantees on securities backed by credit card debt and accounts payable.

Case Studies

Switzerland: Good Bank/Bad Bank Split in the Case of UBS as of May 2009

Information on Bank Asset Quality and Participation

The Swiss case in fall 2008 was relatively straightforward. Switzerland has only two systemically important banks. Only one of them, UBS, had substantial exposure to U.S. subprime mortgage securities by fall 2008. Therefore, the Swiss authorities focused their restructuring efforts on UBS. UBS voluntarily participated in the plan. Credit Suisse was initially offered the opportunity to participate in the same plan but declined.28

Overview

The plan was a combination of asset sales to an asset management fund (the bad bank) and recapitalization by convertible notes. Almost all transfers were up front. UBS is not liable for future losses on transferred assets but kept a partial share of its upside. There are two potential sources of subsidies: (1) the price of transferred assets could be higher than the fundamental value of the assets net of the buyback option’s value, and (2) the issuance price of convertible notes could be above fundamental value.

Asset-Side Restructuring: Asset Sales

In October 2008, the Swiss authorities and UBS removed toxic assets by creating a special purpose vehicle (StabFund) to hold them under the Swiss National Bank.29 The StabFund was to be the bad bank, and the remainder of UBS was supposed to become the good bank. Up to US$60 billion in toxic assets was allowed to be removed from UBS, whose assets totaled almost US$2 trillion at that time. UBS provided 10 percent of asset value (i.e., up to US$6 billion) for the equity of the bad bank but immediately transferred the equity ownership to the Swiss government for US$1. The US$6 billion would cover the first 10 percent of losses of the StabFund. The Swiss National Bank lent the StabFund additional funding, up to US$54 billion at the London interbank offered rate (LIBOR) plus 250 basis points. The future loss of the StabFund would not be charged to UBS (nonrecourse condition), but UBS retained some upside option.30 In the end, UBS transferred only $39 billion of its assets to the StabFund. The price was set by an independent valuation process.

Liability-Side Restructuring: Recapitalization

Although the asset side of UBS was improved by asset sales as described above, the original plan did not include restructuring of the liability side, but UBS did end up being recapitalized. UBS received capital of US$6 billion from the Swiss government by issuing mandatory convertible notes at 12.5 percent interest. The proceeds were intended to finance the same amount of UBS’s equity injection in the StabFund, which was immediately valued at US$1. If UBS had injected the equity to the StabFund up to the limit of US$6 billion, there would have been no increase in the capital of UBS. However, because UBS ended up transferring only about US$4 billion to the StabFund, UBS was able to retain US$2 billion worth of capital in net. See Figure 16.11 for a schematic of the plan.

Figure 16.11UBS Restructuring

(announced plan, billions of U.S. dollars)

Source: Authors’ illustration.

Note: A = assets; D = debt; E = equity.

Corporate Governance

UBS shareholders had already suffered through voluntary recapitalization in April 2008 by new equity issuance (rights issue) without any public help. The old management also had to exit in April 2008, at the annual general meeting of the shareholders, when UBS asked for the rights issue.31

United Kingdom: Recapitalization and Asset Guarantee for RBS and Lloyds-HBOS as of May 2009

Overview

The U.K. case combines recapitalization and asset guarantees. The initial state-financed recapitalization in fall 2008 of the Royal Bank of Scotland (RBS) and Lloyds-HBOS appeared to be an emergency rescue rather than a preventive measure because it occurred after the realization of large valuation losses. However, asset protection introduced in January 2009 was a preventive measure to avoid future defaults. The government also asked the banks to continue lending to homeowners and small businesses.

Liability-Side Restructuring: Recapitalization

By fall 2008, it was clear that RBS and HBOS were in trouble. In October 2008, the U.K. authorities decided to offer a recapitalization scheme to systemically important banks, targeting RBS and newly merged Lloyds-HBOS.32 The government injected capital with preferred shares and ended up owning 58 percent (£20 billion) of RBS and about 44 percent (£17 billion) of Lloyds-HBOS.

Asset Guarantees Combined with Government Ownership

In January 2009, additional measures were taken. A large portion of RBS’s and Lloyds-HBOS’s assets were guaranteed (under the Asset Protection Scheme): £325 billion (14.5 percent) of end-2008 assets for RBS and £260 billion (23.4 percent) of end-2008 assets for Lloyds-HBOS.33 If the valuation of assets were to fall below a particular threshold,34 the government would compensate the loss up to 90 percent.

The asset guarantee was not offered for free. The insurance fees were to be paid in preferred shares. For Lloyds-HBOS, the government would own close to 50 percent of the total economic stake. For RBS, in addition to insurance fees, the government announced an extra injection of capital through preferred shares. The government’s economic stake would rise to more than 80 percent. With the conversion of preferred shares to common equity, the voting rights share of the government for RBS became about 70 percent.

Corporate Governance

As the majority shareholder, the government needs to monitor bank management. In the October 2008 plan, the government obtained the right to appoint new independent nonexecutive directors. In addition, the government limited executive compensation and dividend payouts.

United States: The Geithner Plan as of May 200935

In the United States, the relative asset quality of systemically important banks was not fully known in fall 2008. The authorities needed to take into account this lack of information when they designed the first-round rescue plan at that time.

Given the information problem, the treasury encouraged many banks to participate in a recapitalization program. Banks could receive cash by offering preferred shares to the treasury. The recapitalization was across the board with few conditions.36 The recapitalization was accomplished under the Capital Purchase Program as a part of the Troubled Assets Relief Program (Paulson Plan) in October and November 2008.37

An exception was made for Citibank in November 2008 because of an urgent situation. Citibank received additional recapitalization as well as asset guarantees from the treasury, the FDIC, and the Federal Reserve. In January 2009, both measures were formalized as the Targeted Investment Program and Asset Guarantee Program, respectively, and extended to Bank of America. Terms and conditions were determined on a case-by-case basis.

The Geithner Plan: Restructuring Based on Better Information

Overview

In February 2009, the U.S. Treasury announced a comprehensive bank-restructuring plan, the Financial Stability Plan (Geithner Plan). The plan tried first to evaluate the asset quality of systemically important banks through a specific examination of their assets’ risks (stress test or Supervisory Capital Assessment Program).38 This evaluation was compulsory for the 19 largest banks. Then the plan combined recapitalization (Capital Assistance Program) and asset purchase using private money (Public-Private Investment Program). These programs were voluntary in principle but semivoluntary in practice because banks had to meet the required capital criteria. In addition, the plan included several conditions to prevent misuse of public money and to facilitate lending. The plan also encouraged banks to lend, especially to small businesses and communities, and to support homeowners, especially those facing foreclosure.

Information Gathering and Communication

In early May 2009, the treasury reported the detailed results of the comprehensive stress test, the Supervisory Capital Assessment Program, which is a forward-looking examination of bank solvency, identifying how much capital was needed to cope with future adverse shocks to the asset quality of each bank. The stress test evaluated the future downside risk more rigorously than a typical bank examination. The results confirmed that the largest banks were not insolvent and determined how much extra capital was needed, if any, for each bank to weather a future adverse shock.

Liability-Side Restructuring: Recapitalization

Banks were required to raise the extra capital identified by the stress test. This compulsory feature eliminated the signaling problem described earlier in this chapter. Banks could raise capital through private markets or by participating in the Capital Assistance Program. In this program, banks would receive capital from the government by issuing preferred shares that would automatically convert into common equity after seven years. An earlier conversion could be made at the issuer’s discretion with the approval of the regulator. The use of such hybrid securities minimizes the future cost of financial distress should asset values deteriorate further (as discussed previously). The investment of the treasury is managed under a separate entity (Financial Stability Trust).

Asset-Side Restructuring: Asset Sales

Under the asset sales scheme (Public-Private Investment Program), the government solicited private investors for the purchase of troubled (legacy) loans and securities from banks. Slightly different schemes were provided for loans than for securities. However, the key idea was to use private expertise and solicit it by guaranteeing against the future losses and providing subsidized loans.

Several funds were to be set up to purchase legacy loans. Each fund was to buy pools of legacy loans sold by banks. The price would be determined by competitive bidding by funds. In addition, inexpensive financing was to be available—each fund would receive 50 percent equity participation from the treasury without voting rights and could also issue debt guaranteed by the FDIC (leverage ratio up to 6). The FDIC was to supervise the funds.

In addition, several funds were to be set up to purchase legacy securities from banks. Eligible securities were nonagency residential-mortgage-backed securities that were originally AAA rated and outstanding commercial mortgage-backed securities and ABS that were rated AAA. The treasury again was to provide a 50 percent equity stake without voting rights and lend money to each fund at up to a 2-to-1 leverage ratio. These were to be nonrecourse loans: If the asset values turned out to be very low, funds could default on the treasury, and fund managers would not have any responsibility other than their losses on their own investment in the funds.

The fact that the plan involved a government transfer is in line with this chapter’s analysis of noncompulsory plans—a transfer is needed to convince banks to participate. Private sector involvement would lower the fiscal costs by using private sector money as well as private sector expertise. Further evaluation of the plan requires assessment of whether it minimized the level of the government transfer, given the recapitalization objective. For this, it is necessary to evaluate how close the plan was to an optimal compensation scheme. There are two dimensions to consider. The first is the moral hazard problem in running the asset management funds. The inexpensive government-sponsored leverage was necessary to encourage private investors to take risks, but the risk taking might have become excessive, more than optimal. The second consideration is the calibration of the subsidy necessary to secure the participation of high-quality managers. A difficulty with the plan was estimating how the public subsidy was to be shared between the banks and the fund managers (as Spence, 2009, stressed). It has been argued that the optimal subsidies could have been calibrated using an auction to sell the management and cash flow rights (Bebchuk, 2009). This would have required thorough preselection of qualified managers but might also have set the equilibrium transfer to the banks at an amount less than intended, which could have discouraged banks from participating in the plan.

Corporate Governance

To address potential moral hazard problems, the plan required banks to restrict executive compensation, dividends, stock repurchases, and acquisitions. At the same time, the plan prohibited political interference in investment decisions, and the Treasury made all contracts public.

Conclusion

When designing a restructuring plan for a systemically important bank, a key issue is limiting transfers from taxpayers. Limiting such transfers prevents unnecessary subsidies to debt holders and maximizes the economic value created by the restructuring. There is no magic bullet. Table 16.1 summarizes the pros and cons of various policy options. Some of the key findings are the following:

  • In a Modigliani-Miller (1958) framework in which cash flows are independent of capital structure, restructuring is theoretically possible by converting some debt into equity. However, this is difficult in practice.

  • If debt contracts are not changed, all restructuring involves transfers from the government. A plan subsidizing common equity issues and buying back debt is close to optimal. Subsidized asset sales are more costly to taxpayers because debt holders benefit more.

  • The precise design of a restructuring should take into account the value created or destroyed because of changes in the participants’ behavior. Managers’ expertise and incentives are concerns that should be addressed in restructuring.

  • If assets are undervalued as a result of liquidity or “lemons” problems, the government can make profits by buying assets above market value but below fundamental value. A caveat is that such undervaluation is difficult to assess.

  • Asymmetric information on the value of future payoffs makes equity holders even more reluctant to support restructurings involving new-claim issues. A restructuring impasse can be avoided through (1) conducting stress tests with credibly publicized results, (2) using compulsory rather than voluntary schemes, (3) providing contingent guarantees for banks to avoid new-claim issues, or (4) making banks issue low-information-sensitive claims such as convertible debt or preferred stocks.

  • From a long-term perspective, it is important that managers and shareholders of bailed-out banks be punished in a way that discourages excessive future risk taking.

Table 16.1Pros and Cons of Various Policy Options1
Constant surplusEndogenous surplus2Future concerns2Other concerns
First best(Honoring debt contracts)Talent allocationMoral hazardAdverse selection3Near future distressLong-run view punishmentRegulatory requirementUp-front taxpayer cost
(1)(2)(3)(4)(5)(6)(7)(8)(9)
Nonstate-contingent measures
Debt-for-equity swap+n.a.n.a.n.a.n.a.n.a.n.a.+
Recapitalization (with debt reduction)
With common equityn.a.++
With convertible notes
(Holder converts or mandatory)n.a.++
(Issuer converts)n.a.+++
With preferred sharen.a.+++
With subordinated debtn.a.++
Asset purchase (Either via asset management company or good bank/bad bank)n.a.+
State-contingent measures
Limited loss guarantee on assets for banksn.a.++++
Loss guarantee on liability for liability holdersn.a.++++
Recapitalization with loss guarantee on equityn.a.++++
Only for new equity holders (Caballero)
Good/bad bank split with recourse conditionn.a.+++
With loss paid by equity of good bank (Sachs)

+ indicates the restructuring plans that are worth considering; − indicates those that should be avoided.

Assessment is made for the cases without renegotiating the debt contracts.

Assessment is based on voluntary plans. Compulsory plans can eliminate this problem. Also, the government can mitigate this problem with rigorous bank examination.

+ indicates the restructuring plans that are worth considering; − indicates those that should be avoided.

Assessment is made for the cases without renegotiating the debt contracts.

Assessment is based on voluntary plans. Compulsory plans can eliminate this problem. Also, the government can mitigate this problem with rigorous bank examination.

Overall, the restructuring of a systemically important bank should combine several solutions to resolve multiple concerns and trade-offs on a case-by-case basis. In fact, the case studies are in line with this analysis. Although different schemes were used in Switzerland, the United Kingdom, and the United States, all of them employed measures both on the asset side (e.g., sales of toxic assets) and on the liability side (e.g., recapitalization with preferred shares). In addition, the speed of events appeared to be a major friction when the restructuring plans were designed. However, there may be room for improvement. In particular, the costs to taxpayers and the final beneficiaries of the subsidies should be more transparent in all plans. Treatment of managers and shareholders could be less favorable.

A restructuring plan cannot be judged by the stock market reaction. That reaction depends on the gap between ex ante anticipations and the announced plan—anticipated transfers may be larger or smaller than those in the announced plan. Moreover, even if the announcement comes as a surprise, a stock price increase may not be good news. On the one hand, it may suggest an increase in surplus, both private (e.g., reduction in the cost of financial distress) and social (e.g., stabilization of the financial system). On the other hand, it may also suggest too high a transfer to shareholders from taxpayers. A good compulsory plan may clearly be associated with a decrease in stock prices because shareholders are forced to take some responsibility.

In the long run, various frictions can and should be reduced to make the restructuring of systemic banks less complex and less costly. Specifically, a better legal framework should be designed so that the renegotiation of debt can be handled more quickly and with a smaller threat of systemic meltdown. For example, opacity can be reduced by more timely and in-depth disclosure requirements for bank asset information and counterparty exposures. Regulation can give banks more incentives to include conversion clauses in their long-term debt contracts so that such debt will automatically convert into equity in a distress situation.

References

If a bank is not systemically important, a government should apply standard procedures, such as those defined in the Prompt Corrective Action law in the United States.

A more practical definition of insolvency is regulatory insolvency. Under regulatory solvency, certain positive equity is required to be solvent, that is, a bank is solvent if the book value of assets is large enough (A > D + required capital). However, the thrust of the analysis would not change; thus, a simple condition of solvency, V(A) > D, is used throughout this chapter.

The marginal threshold of the realization of A1 to achieve the target default probability is A* = F–1(p*). Put differently, if the debt is restructured to have face value A*, then the default probability will be p*. The social costs associated with default are assumed not to be sensitive to the recovery rate of debt in the event of bankruptcy.

This scheme is possible only when debt holders and equity holders negotiate freely and reach agreement easily. In practice, this amiability is difficult outside a bankruptcy regime. Zingales (2009) argues that this solution can be achieved by changing the bankruptcy law for banks. Note that in this truly frictionless framework, it is sufficient to prevent default with an ex post debt-for-equity swap that is triggered when the realized asset value is less than the debt obligation, A1< D. In other words, no ex ante restructuring is needed.

It is assumed that the social benefits from saving a systemically important bank are limited; thus, the government will not transfer funds beyond the upper limit D – A*. However, if there is a need to transfer money to counterparties in case of default, a subsidy that gives higher debt recovery given default A1< A* may be optimal.

Issuance of new (nonconvertible) debt would increase the default probability and is thus not a possible restructuring scheme.

Conversion options in hybrid securities are further discussed below.

It is more costly for taxpayers to issue convertible subordinated debt (i.e., junior to preexisting debt) with conversion not determined by the issuer. In this case, although the trigger point is still the same as in Figure 16.6, panel a, the preexisting debt holders will be given priority in a default. This extra gain imposes an extra cost on taxpayers.

This is a conservative assumption in evaluating taxpayer transfers, because it implies that the bank is not able to buy back debt secretly and restructure afterward by surprise.

This scheme is equivalent to finding some debt holders that agree to convert into equity at the postrestructuring price, which is higher than the current market price but below the face value.

The parameters α and m can be picked as the solutions of two equations. The first equation states that the probability of default is p* (1 + m) a V(A) + (1 – a) A* = D. The second equation states that the negative net present value of the government’s injection covers the increase in the value of debt, a m V(A) = V (D;a)V(D)). The new value of debt, V'(D;a), depends on the sales fraction a.

The probability of default is equal to prob((1 − a) A1 < Dcash), equivalently, prob (A < (Da V(A))/(1a)). Hence, the required fraction of assets a should solve (1 − a) A* = Da V(A). For a given realization of asset value A1 that makes the bank default (A1 < A*), the debt holders recover cash a V(A) and liquidation value (1 − a) A1, that is, D − (1 − a) (A*−A1), which is more than in the equity issue case, D(A*A1).

A significant fraction of the value generated by these projects would go to the debt holders, whereas the costs would be fully paid by the equity holders. Because the latter have the control rights, the bank will not finance these projects (Myers, 1977). There is a vast amount of literature on the costs of financial distress and debt overhang, for example, summarized in Tirole (2006).

Liquidity policies aim to reduce the cost of financial distress and may indirectly reduce the probability of default. Examples include accommodating monetary policy (both conventional and unconventional measures), loss guarantees for debt holders, and (implicit) subsidies for new lending. Such policies are outside the scope of this chapter.

In other words, the cumulative density function of default probability F shifts to the right when a restructuring occurs, and becomes F '(•) = F(• + C).

A key risk is the collapse of the decentralized payment system (Rochet and Tirole, 1996).

Government also has a direct stake in the bank, given that it typically provides deposit insurance.

In fact, the optimal p* can be determined by maximizing total surplus S as a function of restructuring design, taking into account the optimal bank capital structure, payment-system implications, and macroeconomic consequences.

How a bank evaluates securities and business loans is difficult to know. Under the current accounting rules, even securities with market prices do not need to be evaluated at the market price (they can be “marked to model”). Moreover, the composition of assets is also difficult to know, at least in real time.

The assumption is not restrictive. The case in which high-quality banks are healthy (i.e., pH < p*) can be analyzed in a similar fashion.

Negative market perception translates into a high financing cost in the interbank market and even a possible bank run. A similar situation was analyzed first by Majluf and Myers (1984).

Although it is not always possible, the government could save some informational costs by differentiating between two types of banks in a separating equilibrium in which low-quality banks self-select into equity-based recapitalization that does not attract high-quality banks. However, the costs of asymmetric information would not be removed completely because the issuance of equity by low-quality banks occurs at a high financing cost, which would need to be compensated for. A separating equilibrium would require a menu of contracts, which is quite sensitive to distributional assumptions on asset quality among banks and are difficult to implement in practice. We therefore refrain from the analysis.

Debt is said to be less information sensitive, whereas equity is information sensitive.

If the option or timing of conversion is at the discretion of the issuer, the issuer will convert in bad times, not in good times, so that the convertible issue will lose its signaling virtues. This contrasts with the benefit under the other objective, because it is clearly a good instrument for a bank in distress, especially from a medium-term perspective (see “Recapitalization by Issuing Preferred Stock or Convertible Debt” earlier in the chapter).

Regulatory reform is beyond the scope of this chapter. However, we would like to note that if mark-to-market accounting were weakened, the degree of the asymmetric information problem would increase. To mitigate the regulatory distortion, it would be better to design countercyclical capital-ratio regulation while keeping mark-to-market accounting.

Philippon and Schnabl (2009) analyze a case in which the asset quality and future profits are uncorrelated. Then, the problem regarding the asymmetric information on asset quality and the problem of revealing future profit opportunities are distinct from each other. If the government uses only one tool (e.g., asset purchase or recapitalization), there can be a preferable policy—recapitalization with common equity in their analysis.

This solution is the norm for smaller banks. See also cases for systemically important banks in Japan, in particular, Long-Term Credit Bank and Nippon Credit Bank (Hoshi and Kashyap, 2008).

Credit Suisse raised US$10 billion in new capital by selling equities and hybrids to private sources (including a sovereign wealth fund).

The assets purchased were primarily U.S. and European residential and commercial mortgage-backed securities.

Once this loan is fully repaid by the StabFund, UBS can exercise its option to repurchase the fund equity by paying the Swiss National Bank US$1 billion plus 50 percent of the equity value at the time of exercise in excess of US$1 billion.

The first-round recapitalization by UBS was in October 2007 by convertible note issues to a sovereign wealth fund of Singapore and a private investor from the Middle East.

RBS raised capital using a rights issue in April 2008 without government help. Lloyds was relatively healthy before acquiring troubled HBOS. In October 2008, as a liquidity measure, the government introduced the Credit Guarantee Scheme, which applied to a wider set of banks. This provided insurance for debt holders, thereby lowering banks’ financing costs. In January 2009, the Asset-Backed Securities Guarantee Scheme was introduced to complement the Credit Guarantee Scheme because the latter excluded nonstructured instruments. This second scheme essentially aimed to facilitate new mortgage lending, given that it guaranteed the value of originally AAA-rated mortgage-backed securities issued only after January 2008.

As an expansion of monetary policy (i.e., liquidity injection), the Asset Purchase Facility was introduced in January. It was funded by the treasury and established within the Bank of England. The Bank of England used it to improve corporate credit liquidity and to meet the inflation target.

This was tailored to each bank. The first-loss amounts (i.e., threshold) were £19.5 billion (6 percent) of protected assets for RBS and £25 billion (9.6 percent) of protected assets for Lloyds-HBOS.

Actual implementation of TARP funds evolved further. However, this chapter records discussions on proposed plans as of May 2009, when this chapter originally was completed after numerous iterations from January 2009.

Some conditions (e.g., limit to executive compensation) were applied after recapitalization.

As a liquidity measure, new debt holders of Federal Deposit Insurance Corporation (FDIC) member banks were temporarily insured by the FDIC under the Temporary Liquidity Guarantee Program. Moreover, the Federal Reserve began lending up to $200 billion on a nonrecourse basis to holders of certain AAA-rated asset-backed securities (ABS) backed by newly and recently originated consumer and small business loans (Term Asset-Backed Securities Loan Facility). Banks were given incentives to increase new lending given that they would not face the downside risk of valuation loss in the ABS.

The authorities also planned to increase balance sheet transparency and disclosure.

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