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International Monetary Fund and Austrian Financial Market Authority. Patrick Darlap, Alessandro Giustiniani, Heiko Hesse, Philipp Hochreiter, Gregorio Impavido, Jaime Jaramillo-Vallejo, Toshi Kurosawa, Martin Larch, Luc Laeven, David Parker, Alvaro Piris Chavarri, Alexander Tieman, Thierry Tressel, and participants at the April 2013 International Atlantic Economic Society conference provided helpful comments.
An important practical issue is whether preferred status should be awarded to deposits in excess of the guarantee ceiling.
Typically, for example, the receiver’s administrative expenses and tax obligations are given highly preferred status. There may be different treatment also, for example, for residents and nonresidents. Yet, as will be documented, even where there are well-defined rules for allocating residual assets among creditor classes, bankruptcy costs can be high, in part because of the inconsistent of claims of creditors within each class.
So-called “skin in the game.”
Banks typically have relatively few real assets that are easily realizable.
The Korean Asset Management Corporation (KAMCO) purchased nonperforming loans (NPLs) with a face value of won 110 billion in the aftermath of the 1997 banking crisis. Its operating expenses amounted to about 20 percent of this stock, of which direct administrative and selling expenses made up 4.2 percentage points (He, 2006).
In addition, several hundred employees were retained.
Lehman Brothers did not have deposit liabilities in the United States but its experience is still illustrative of the difficulty in establishing claims.
Similar disputes affected the resolution of smaller and generally less complex financial institutions. In May 2012, Ally Financial Inc., which is mostly engaged in auto financing, agreed to give $750 million to its ResCap subsidiary to settle claims brought by bondholders and others (see http://www.bloomberg.com/news/2012-05-15/ally-pays-750-million-in-rescap-bankruptcy-to-avoid-the-noise-.html). At the time of writing, various creditors are reportedly still seeking compensation.
Litigiousness is widespread. For example, the Irish government may be sued by various claimants over a planned bank debt restructuring deal (“Dublin faces lawsuit over IBRC liquidation,” Financial Times, February 19, 2013).
Much of the literature on banking concentrates on matters related to asymmetric information, limited verification, monitoring costs, moral hazard, and adverse selection (Freixas and Rochet (2008) survey the main contributions). These approaches can explain rationing, collateralization, and many other observed phenomena, but they are not inconsistent with the approach taken here.
See http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137627.pdf and http://www.european-council.europa.eu/home-page/highlights/leaders-review-progress-in-strengthening-economic-and-monetary-union?lang=en.
Some individual states had had depositor protection already.
The last point is related to the argument that providing a deposit guarantee, especially to large depositors and providers of wholesale bank funding, reduces the incentives for these agents to exercise market discipline (Demirgüç-Kunt and Huizinga, 2003 and Hovakimian, Kane, and Laeven. 2003).
It is also then easier to net an individual’s deposits against loans outstanding.
Their comments are available at http://www.bba.org.uk/media/article/angela-knight-banking-reform-white-paper-needs-to-bring-certainty-in-key-ar.
Assets of non-banks are often highly encumbered: a household with a mortgage may in effect have encumbered all its assets except human capital. Insurance companies’ assets are largely pledged to policy-holders.
However, if claimants are risk averse, those who have most of their assets tied up in the failed bank may be willing to fight hardest when the residual assets are small. A form of moral hazard might prompt some to undertake a “gamble for resurrection.” One could also envisage contest technology such that the contest is most intense at an intermediate level of residual assets; when there are ample residual assets, everyone might easily accept a small “haircut,” and when no assets remain, the contest ends. The main results of the model would go through under such an alternative.
The strongly asymmetric case is addressed in depth in Welch (1997). A bank may plausibly have one or a few major creditors, one of which might be the central bank or the deposit guarantee fund, but also many smaller creditors. Prudential regulations normally require banks to diversify assets and liabilities.
This case corresponds to how resolution through purchase and assumption is meant to work: should intervention be necessary, the DGS quickly sells preferred deposits and corresponding assets to a sound bank, and any contest over residual assets is left to other claimants.
The model is broadly similar to that used in Hardy and Tieman (2008), adapted to focus on the issues of concern here.
Use of a more general distribution function would leave results qualitatively unchanged.
The book value of the assets encumbered by the obligation to preferred depositors may exceed the value of those deposits if realizing the assets in case of resolution is costly; in effect, a “haircut” needs to be applied. If it costs, say, one tenth of an asset’s value to realize it and use it to meet a depositor’s claim, then the committed assets amount to 10/9-th of the deposits.
One could allow a fixed cost to enter the specification of bankruptcy costs, which would creates a range of low values of r, wherein unsecured claimants give up trying to recover assets because costs exceed any possible gain. Introducing this feature would not contribute to the main themes of this paper and add considerable algebraic complexity, because the range where lobbying is abandoned would depend on several of the other variables. Specifically, suppose that fixed costs are c0. Then lobbying is no longer profitable when r falls below c0/(1 − c1) − q + idd.
Note that, by assumption, (q − idd − is(1 − d)) < 0; otherwise bankruptcy would not be possible. Formally there exists an alternative solution to the quadratic equation with a positive sign before the square root term. For some parameter values, that solution falls in the permissible range of [0, 1]. However, it is unstable in that, for example, an increase in q (c0) would then increase (decrease) the probability of bankruptcy. Were equation (6) modified to incorporate risk aversion or a more general probability density function, multiple stable equilibria could be obtained for some parameter combinations and functional forms.
The result may not hold if id ≫ is.
There is formal evidence that deposit insurance reduces interest rates on deposits (Demirgüç-Kunt and Huizinga, 2003).
One effect of the availability of collateralization or securitization is to increase banks’ desire to hold assets that are relatively easy to package in this way, and reduce their willingness to provide other forms of financing, including perhaps loans to small and medium enterprises. Here it is assumed that each bank faces infinitely elastic demand for loans of different sorts.
Even if the failed bank has ample residual assets, legal uncertainty can arise if legislation is not well formulated or is absent. The advantage of a very strong legal framework is illustrated by the case of covered bonds, the bankruptcy remoteness of which is supported in many countries by dedicated legislation and legal precedent, such that covered bond holders have an uncontestable claim on both the issuing bank and the underlying assets. Nominal losses on German Pfandbrief are virtually unknown in the 250 years since their introduction.
The “haircut” on collateral needed to ensure that collateralized loans can always be repaid is (1 − q − idd − f(e)).
The U.S. “prompt corrective action” framework is based mainly on capitalization levels.
Early intervention may increase the parameter q.
The “conflict technology” may be complex; possibly, a small number of claimants, each with a relatively large share of claims, might very fight intensely, or it could be that the DGS can internalize conflict and allocate residual claims relatively easily, perhaps assisted by financing from government and the ability to impose higher premia on surviving banks.
The European Systemic Risk Board recently issued recommendations to enhance prudential oversight of asset encumbrance and related market transparency, but explicitly prohibits the revelation of data on assets encumbered to central banks (see “Recommendations of European Systemic Risk Board of 20 December 2012 on funding of credit institutions (ESRB/2012/2), available at http://www.esrb.europa.eu/pub/pdf/recommendations/2012/ESRB_2011_2.en.pdf?e622821b9c3171124f1d85f3a1b4d40e).
The lack of such relatively safe investment vehicles may be a contributing factor to low savings by poorer households and some developing countries.