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The paper benefited from discussions with Wilson Ervin (Credit Swiss AG), Mark Flannery (University of Florida), Charles Goodhart (London School of Economics), and Knox Mcllwain (Cleary Gottlieb Steen & Hamilton LLP). We are grateful for the comments provided by Jonathan Fiechter, Sean Hagan, Daniel Hardy, Ross Leckow, David Parker, Ceyla Pazarbasioglu, Robert Sheehy, and José Viñals, and the excellent assistance provided by Charmane Ahmed. The views expressed in this paper are those of the authors.
The elements of an adequate policy framework to deal with the too-big or too-important-to-fail problem should contain (i) more stringent capital and liquidity requirements to limit contribution to systemic risk; (ii) intensive supervision consistent with the complexity and riskiness of the institutions; (iii) enhanced transparency and disclosure requirements to capture emerging risks in the broader financial system; and (iv) effective resolution regimes at national and global levels to make orderly resolution a credible option, with resolution plans and tools that lead creditors to share losses (Otker and others, 2011).
Though this paper discusses the concept of bail-in as a resolution tool for systemically important banks and nonbanks alike, the structure and design details of resolution regimes for systemically important nonbanks can differ from those applicable to banks.
In some proposals, bail-in was more broadly defined to also include a contractual approach to write down and convert non-equity liabilities; for examples, contingent capital instruments or a broader set of contractual “bail-inable” debt instruments.
CIT Group filed for Chapter 11 bankruptcy protection on November 1, 2009, with $71 billion in assets and support from its creditors. It emerged from its bankruptcy proceedings 38 days later, after its creditors reached an agreement on a voluntary debt restructuring plan.
The systemic nature of a financial institution would also depend on the market conditions. At a volatile time, the failure of a relatively small institution could also have a destabilizing impact on the financial system.
For example, Lehman’s bankruptcy has involved five bodies of laws applicable to its various corporate entities, including over 80 jurisdictions’ insolvency laws applied to its non-U.S. entities (Summe, 2011), with legal costs exceeding $1 billion and still rising.
The FDIC has used three basic resolution methods for failing institutions: P&A transactions (most commonly used), deposit payoffs, and open bank assistance transactions (which are no longer commonly used). The OLA specifically focuses on mitigating the systemic risk of disorderly liquidation of financial positions by granting the FDIC the authority to suspend the termination rights in “qualified financial contracts” (QFCs) as defined in the Federal Deposit Insurance Act by one business day and allowing the FDIC a short period of time (up to three days if a resolution commences on a Friday) in which it may transfer QFCs to a solvent third party or to a bridge company. If a transfer occurs, the counterparties would continue to be prohibited from terminating their contracts and liquidating and netting out their positions solely on the basis of the appointment of a receiver.
Further work on the design of mandatory debt restructuring will be carried forward through the FSB, its Resolution Steering Group, and Legal Advisory Panel; the last is providing more detailed legal analysis and recommendations on implementing the recommendations of the FSB with respect to resolutions.
One question raised was whether bail-in could form part of the general framework for enforcement measures and remedial actions, which would apply before reaching a stage of deterioration or difficulty requiring formal resolution (e.g., prompt corrective action or PCA). Our view is that the triggers for taking enforcement actions, usually along the lines of violations of law or regulations or unsafe or unsound practices, are not necessarily sufficient to justify the direct effect on third-party rights (both creditors and shareholders) that are entailed in statutory bail-ins.
Many jurisdictions have some form of such a regime, though it may be called by other names such as temporary administration, interim administration, statutory management, conservatorship, or other similar terms.
Such public-interest tests could include references to whether the intervention would likely maximize the value of the institution, minimize its losses to creditors and other stakeholders, preserve its going-concern value for the benefit of creditors and other stakeholders, and avoid or mitigate any severe disruption in the stability of the financial system.
Basically, pre-insolvency shareholders should not inappropriately benefit from haircuts on creditors. Therefore, in case of early pre-insolvency triggers where losses may not be large enough to eliminate shareholders completely, senior creditors should not be subject to outright haircuts but only to debt-to-equity conversion, so that the pre-insolvency shareholders are diluted.
This is the case in Japan, where the FSA may apply to the court to open proceedings.
As suggested by the Japanese bank-debt-restructuring framework, the centralization of procedures in certain (specialized) courts may also be useful.
In Italy, the creditors do not have a say in the haircuts imposed upon banks.
If the pre-insolvency triggers were too early, for example, prior to a breach of regulatory minimum, the determination of the test for proceeding with the restructuring would be more complicated, since creditors could argue that alternative recovery action (recapitalization, asset disposals) might avoid imposing haircuts.
But this would not be the case for those jurisdictions whose insolvency framework includes forced debt restructuring mechanisms.
A further question that may affect the legal analysis would be whether the differential treatment should be automatic or discretionary for the resolution authorities.
On the creation of such different classes on the basis of different economic interests: see Hagan (1999), pp. 66–67.
This would be similar to “debtor-in-possession” rules in the U.S. Chapter 11 framework.
Some have raised the question of whether resolution frameworks in general and bail-in in particular could be applied on a group-wide basis. However, there is very little support among policy makers for collapsing the estates of the components of a banking group into one single insolvency estate.
This assumption is made to streamline the discussion of cross-border issues rather than to take a specific position on what jurisdiction should take the lead in resolving a problem bank. What will be important is that there is agreement in advance regarding which jurisdiction should control the resolution process. This same jurisdiction will likely need to be the one that provides any necessary liquidity until the bank is stabilized.
While some liabilities of a bank may be booked with a foreign branch, ultimately they represent claims on the entire legal entity and should be included in the overall balance sheet of the bank.
Where the host jurisdiction is the jurisdiction of the choice-of-law provision in a debt contract, recognition of an insolvency proceeding will mean that the insolvency proceeding takes precedence over the terms of the debt contract.
Whether the proceeding would be considered an insolvency or insolvency-related reorganization regime may depend on, among other things, the protections the regime provides for the various stakeholders. In the context of bank resolutions, what constitutes an acceptable level of protection will need to be balanced against the reality of the need to act quickly in the interest of preventing contagion and preserving financial stability.
The identification of permissible jurisdictions could affirmatively identify acceptable jurisdictions or, in the alternative, the authorities may establish a list of unacceptable jurisdictions.
For instance, loans from parent banks to subsidiaries would typically not be incorporated in debt securities, but could well be subject to restructuring.
Given that the assets of the most important global institutions may be clustered in a few jurisdictions, agreement among a few key financial centers could make forced bank-debt restructuring a viable resolution technique for financial institutions that are globally systemically significant.
Though work is being done at the international level to develop mechanisms for efficient and effective cross-border recognition, under the current state of affairs achieving recognition may involve court-based processes that can take time. Furthermore, the complexity of various legal doctrines that may achieve recognition makes it difficult to predict the outcome in any given case.
This vulnerability arises from the inherent risk due to a fundamental mismatch between the long-term illiquidity of physical investments (bank assets), households’/creditors’ desire for liquidity (bank liability), and banks’ function as providers of intermediation between creditors and producers. With the financial innovations (for example, securitization), the intermediation chain has become longer and more unstable and bank runs have extended to wholesale funding, causing a systemic banking crisis. For example, some have seen the recent financial crisis as “a run on repos” (Gorton and Metrick, 2010a).
In Europe, for instance, the support factor for the banking sector contributed up to five notches to the long-term ratings from Fitch for 31 out of the 58 EU banks rated by the credit rating agency at the end of 2010.
Moody’s has indicated that a seven-notch gap between an entity’s credit rating and the corresponding CDS-based, market-implied rating results in the probability of the credit rating being downgraded, increasing by 40 percent over a one-year horizon.
They are cheaper because investors are protected by collateral. A covered bond typically provides a preferential claim on segregated assets and entails a degree of over-collateralization to improve its credit rating, thus undermining the position of senior unsecured creditors by encumbering the highest quality assets.
For example, under the Solvency II framework for European insurance companies, senior unsecured bonds are treated less favorably than covered bonds.