{"id":271336,"date":"2010-01-28T13:14:27","date_gmt":"2010-01-28T18:14:27","guid":{"rendered":"tag:http:\/\/www.economist.com,2009:21004536"},"modified":"2010-01-28T13:14:27","modified_gmt":"2010-01-28T18:14:27","slug":"bail-in-roundtable-author-interview","status":"publish","type":"post","link":"https:\/\/mereja.media\/index\/271336","title":{"rendered":"Bail-in roundtable: Author interview"},"content":{"rendered":"

This week\u2019s Economics focus<\/a> is a guest article by Paul Calello, the head of Credit Suisse\u2019s investment bank, and Wilson Ervin, its former chief risk officer. In it they propose a new process for recapitalising failing banks with shareholders\u2019 and creditors\u2019 money. We asked them a number of follow-up questions on the detail of their proposal.<\/em><\/p>\n

Your goal is to make creditors and shareholders bear the pain of recapitalising a failing bank. Why aren\u2019t ideas such as contingent capital, a new form of subordinated debt that turns into equity when capital levels fall to a certain point, enough to achieve this aim? <\/strong><\/p>\n

We support the idea of contingent capital, and think it could work in concert with the Bail-in concept.  A well designed contingent capital instrument can create good management incentives \u2013 for example, encouraging more capital to be raised early in a crisis, and focusing boards and managers on risk management.  And the extra capital it provides directly might be sufficient for moderately sized stress events.<\/p>\n

However, contingent capital instruments alone may not provide sufficient equity to solve a really serious crisis, or work for \u201coutlier\u201d institutions. For example, would $5 billion of contingent capital really have been enough to stem the tide in the case of Lehman?  Unless the layer of contingent capital was very thick, the final result might have been the same for many banks.<\/p>\n

In essence, the Bail-in process taps all layers of existing unsecured debt capital to provide contingent capital in a crisis.  By doing that, it makes the layer of potential new equity capital very thick, so it maximizes the chance that the institution can avoid failure and a disorderly liquidation.  And it\u2019s also more efficient to ask existing creditors to accept their responsibility for bearing an appropriate portion of losses, than to engineer an entirely new layer of capital to do so.<\/p>\n

You seem to stress the importance of keeping troubled institutions as \u201cgoing concerns\u201d, whereas many regulatory proposals are about enabling more orderly liquidations. Is this just another way of ensuring that big financial institutions cannot fail?<\/strong><\/p>\n

The Bail-in concept is designed to avoid a disorderly failure where possible \u2013 without compromising responsibility or market discipline.  A key objective of this plan is to keep institutions viable as going concerns where possible, because liquidation is costly and can multiply the size of the problem.  In the case of Lehman, we estimate that liquidation added more than $100 billion of deadweight losses onto investors, above and beyond the $25bn of losses that market participants estimated were present on a going concern basis.  It\u2019s much better for investors if we can solve the problem as cheaply as possible.  If costs can be kept in proportion, we dramatically reduce the risk that a problem at one bank can escalates into a crisis that threatens the overall financial system and the economies it supports.<\/p>\n

But while we want to avoid liquidation-style failure because of the high cost, it doesn\u2019t mean that Bail-ins give banks a \u201cget out of jail free\u201d card.  Far from it:  Shareholders can be wiped out.  Management can be fired.  And bondholders do their part by exchanging their obligations into equity capital.  Owners and mangers bear appropriate responsibility, which should incentive good management behavior and market discipline.<\/p>\n

Why does your proposal exempt secured creditors from taking a haircut if a bank gets into trouble? Shouldn\u2019t everyone bear the pain?<\/strong><\/p>\n

Secured creditors should be treated differently because they are investing in a different instrument.  Secured investors accept a lower yield on their loans because they are lending against collateral.  This is different from unsecured creditors who agree \u2013 in advance \u2013 to take the credit risk of the bank directly.  For markets to function well, we think it\u2019s best that the outcomes are related to the nature and intent of the product.<\/p>\n

In addition, compromising the efficiency of the secured funding market could impair the ability of companies to fund themselves in times of stress.  We frequently see companies use secured funding as an additional source of liquidity at a time of difficulty.  Many companies have used this market to avoid bankruptcy, gaining time to work down their assets or consider strategic options.  Given the importance of liquidity in the recent crisis, it seems unwise to make this funding option more difficult.<\/p>\n

Finally, we believe that it is important to avoid mechanisms that could create a \u2018rush to the exits\u2019, which can destabilize the funding of a bank.  By changing a portion of their credit profile from secured to unsecured, we could actually add risk to the system \u2013 by creating an additional class of short term creditors who would run to the exits at the first whiff of danger.<\/p>\n

For a regulator to be able to impose a recapitalisation within a matter of hours, wouldn\u2019t they need a clearer grasp of institutions\u2019 balance-sheets than they apparently did during this crisis? And when those institutions run across international borders, wouldn\u2019t they need to act in concert with other regulators?<\/strong><\/p>\n

We think regulators had sufficient balance sheet knowledge to execute a Bail-in recapitalization, even under the stressed conditions of late 2008.  What they didn\u2019t have was the clear authority to execute one.  If new laws providing for Bail-ins are set out with clarity, the necessary steps are fairly simple and could be executed with a reasonable amount of preparation, even in the severe time constraints of a crisis.<\/p>\n

There are operational elements that could be considered to make implementation work more smoothly \u2013 it is critical that a Bail-in be executed quickly and decisively for the institution to regain market confidence and continue to operate.  For example, a holding company structure could be used to isolate recapitalizations, and keep them separate from operating entities and customer relationships.  To handle inter-creditor issues, regulators could retain an experienced bankruptcy judge, who is skilled in balancing the claims of different classes of creditors.<\/p>\n

In addition, case studies could be published to provide the market with examples of how regulators would have structured a Bail-in for the various resolution events encountered in 2008.  This could aid regulators in future crises – when time is short, and when precedents would be extremely helpful to both policymakers and investors.  There are, no doubt, many operational and legal issues that would need to be confronted and addressed but we believe that these should be manageable \u2013 especially considering the importance of this issue and the drawbacks of the alternatives.<\/p>\n

Lastly, it should be possible to execute a Bail-in framework in a single country, though broad international acceptance would make implementation simpler.  The main international consideration is that some minimum level of cooperation from offshore regulators would be needed, so that local regulators refrained from pre-emptive actions to seize assets or block normal activities, while the overall institution was being recapitalized.  But as long as offshore regulators allowed the primary home market regulator some reasonable deference, we believe international coordination issues should also be manageable.<\/p>\n

You say that investors would continue to invest in big banks despite the risk of a forced recapitalisation since they put their money into other securities with a similar risk. But other industries do not expose them to the risk of regulator-imposed losses within the space of a weekend. Surely this implies a significantly higher cost of capital for the banks?<\/strong><\/p>\n

Our view is that the net cost impact will actually be relatively neutral for well-run institutions.<\/p>\n

The riskiness and cost of a loan depends on two things:  the likelihood of a loss and the severity of a loss.  The Bail-in event should only occur when an institution has exhausted all other avenues \u2013 so the likelihood of trouble is the same.  So the only question is whether the severity will be greater or less.  In the recent crisis, some investors in troubled institutions suffered harsh losses \u2013 as in the Lehman case – while others got bailed out with taxpayer money.  While a cynical investor might like to take his chances and hope for a government bailout, he is exposed to significant political uncertainty that one may occur, and devastating losses if it doesn\u2019t.<\/p>\n

In contrast, a Bail-in event would impose some losses, but they would be much less severe.  In the Lehman liquidation, for example, recovery values for unsecured holding company debt securities have traded in the 15% – 25% area, implying huge losses from par.  In contrast, a Bail-in would allow creditors to keep 85% of their debt whole, and this debt would now be a claim on well-capitalized bank. Moreover, the debt investor would also receive significant new equity in exchange for 15% discount.  The package should be worth something over 90%, a vastly better outcome than the current result.<\/p>\n

Debt investors understand these types of tradeoffs.  They also tend to dislike highly unpredictable outcomes, which were a feature of the various resolution events seen in the recent crisis.  We think that the net cost impact of a predictable, well-structured Bail-in alternative should be relatively modest for well run banks.<\/p>\n

If an institution appears to be getting into trouble, won\u2019t the threat of a forced recapitalisation encourage investors to offload their holdings as fast as they can, increasing the fragility of the institution and the instability of the system?<\/strong><\/p>\n

Institutions in trouble always see some price declines in their securities \u2013 this is a natural result of a normal market process.  The different \u2013 and highly de-stabilizing – element of the recent crisis was the risk of counterparty and customer runs, and the loss of short term funding, such as repo.  This affected the core business of the institutions, depleting their customer franchise and funding support, and making it more difficult for them to survive.<\/p>\n

In the Bail-in structure, the customers and business relationships would be kept whole.  In our Lehman example, the operating divisions of the institution would be protected, so transactional counterparties should feel comfortable staying with the bank.  The risk of a liquidation type bankruptcy would be more remote, so you shouldn\u2019t see customers or short term repo investors fleeing at the 11th hour.  You could still see heavy equity selling \u2013 as with any firm under stress.  But shorting stocks will be less profitable as it will be more difficult to push the institution into a fear-driven collapse.<\/p>\n

The politics of forcing losses onto wholesale creditors are relatively simple. But we have seen in this crisis that it is politically untenable to let retail depositors lose money. Could this scheme work for a bank funded predominantly or entirely by retail deposits? <\/strong><\/p>\n

A Bail-in would not help regulators resolve an entity that is funded entirely by retail deposits.  Our proposal would not force depositors to participate in the debt-for-equity exchange that is central to a Bail-in.  Retail deposits enjoy special government protections in most financial systems, which help avoid the risk of de-stabilizing bank runs, and we do not propose to change this approach.<\/p>\n

However, few large institutions are funded fully by retail deposits.  Almost all of the larger institutions have a significant portion of long term debt funding in preferred stock, subordinated debt and unsecured senior debt.  This debt is typically owned by sophisticated creditors, who understand they are investing in the credit risk of the institution.  This means that, as a practical matter, most of the systemically important banks at the center of the recent debates could be handled via the Bail-in process.<\/p>\n","protected":false},"excerpt":{"rendered":"

This week\u2019s Economics focus is a guest article by Paul Calello, the head of Credit Suisse\u2019s investment bank, and Wilson Ervin, its former chief risk officer. In it they propose a new process for recapitalising failing banks with shareholders\u2019 and creditors\u2019 money. We asked them a number of follow-up questions on the detail of their […]<\/p>\n","protected":false},"author":4534,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[7],"tags":[],"class_list":["post-271336","post","type-post","status-publish","format-standard","hentry","category-news"],"_links":{"self":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/271336","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/users\/4534"}],"replies":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/comments?post=271336"}],"version-history":[{"count":0,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/271336\/revisions"}],"wp:attachment":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/media?parent=271336"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/categories?post=271336"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/tags?post=271336"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}