In this short note we discuss some of the major regulatory changes in crisis management post 2007 – 2009 Global Financial Crisis (GFC) and how these changes relate to the previously haphazard notion of bail-outs. Firstly, and before proceeding any further in our discussion, we define what bailing-out is and why it is considered potentially costly form of government policy intervention. Then, we argue that, yes, given the ongoing rigorous regulatory changes in crisis management post GFC, preventative and/or otherwise, the global financial system appears to be in a more robust shape [1]. In short, we are less likely to see extensive and ongoing bail-outs or large bankruptcies of large financial institutions today as opposed to, as documented, during the GFC [2].
Traditionally and prior to the GFC the expectation of government stepping in and bailing out failing financial institutions, especially “too big” to fail institutions, was implicitly priced-in in the overall market cost of funds these institutions faced. And as such, these institutions faced undue competitive advantage and were in a (clear moral hazard) position to take higher level of risks onto their trading or lending books. The ultimate burden of the losses, however, fell duly on the taxpayers. According to Vila and Peters, and based on Eurostat, between 2008 and 2016, 213 billion euro of public money was used to bail out failed banks [3]. As a result, the cost of bailouts is considerable. Moreover, the haphazard nature of the bailouts during 2008 likely increased uncertainty and a sense of panic [4]. The inconsistent approach to rescue Bear Stearns and then place Fannie Mae and Freddie Mac into conservatorship and then save AIG and leave Lehman Brother to fill-in for Chapter 11 Bankruptcy proceedings only added to the uncertainties [5].
To expand on the previous point, generally speaking, bank bankruptcy differs from other companies because 1) any proceedings are immediate and damaging to the bank’s balance sheet (run on the bank by customers), 2) standard bankruptcy mechanics are not suited for a bank and 3) negative externalities of bank failure can be extensive and if connected can potentially cause cascading negative effects (financial contagion) across the entire banking infrastructure – loss of access to payment systems and lending capacity to households and businesses and loss of overall confidence in banking system, hence the systemic risk definition [6]. As per Armour et.al. in bank liquidation shareholders suffer losses, creditors bear losses based on their debt covenants, any negative externalities are not compensated, and taxpayers are spared from any contributions. Whereas, in case of bank bail-out shareholders once again lose, creditors typically are spared losses all with limited societal losses. However, the taxpayers absorb most of the related costs [7]. Could there be perhaps a solution that provides for neither liquidation nor bail-out mechanism? One of the policy implementations we wish to discuss further became available as part of the ongoing regulatory changes introduced post GFC.
Immediately post the GFC it became evident that tectonic shifts are to be felt across the entire finance and banking space. GFC highlighted the need for effective means of dealing with global institutions considered to be “too big” to fail because of the negative systemic impact and potential negative flow-on effects across the real economy. One of the policy responses and solutions to deal with the above “too big” to fail institutions was an establishment of bank recovery and resolution regimes.
On a global basis, the Financial Stability Board (FSB) has been directing the standards for recovery and resolution[1]. Given the extent of the global regulatory framework, we shift our focus to EU Bank Recovery and Resolution Directive (BRRD) [8]. The banks recovery plan is required to be approved by the Board of Directors before submission to competent authorities (Article 5(9), BRRD). In essence this is bank’s survival plan in case of encountering serious financial difficulties (Article 5, BRRD). On the other hand, bank’s resolution as defined in Article 2 of BRRD is the application of a resolution tool in line with resolution objectives. Critical point to note is, that it is the authorities that determine the fait of the bank in case it is failing or likely to fail and there is no other private intervention to save the incumbent bank. In short, the objectives of the resolution are depicted in Article 31 of BRRD. We believe, it is these changes to regulatory policies as added to the crisis management toolbox post GFC that allow for more timely and cleaner handling of potential future crisis – as opposed to outright liquidation or fully taxpayer funded bail-out.
To expand on the reasons why bank resolution can play critical role in the process. The approach is to provide rapid and stringent solution to a bank in financial distress to maintain financial stability and minimise societal losses (keep taxpayer funds for other purposes). The resolution aims to protect critical shareholders and functions of the failing bank (good bank) and other parts (bad bank) that are not considered critical to financial stability are allowed to fail in liquidation proceedings. Article 34 of the BRRD provides details of the general principles governing resolution.
For our purposes, we focus on the resolution tools. The resolution authority is given a broad coverage of powers in Article 37, BRRD namely, 1) sale of the business, 2) bridge institution, 3) asset separation and 4) bail-in tool. In brief, the resolution authority has the tools and powers to dissect the failing institution and make radical decisions in terms of asset separation and potential sales. Hence, ex ante, forcing the placing the bank management on notice. However, it is not a clear-cut solution. For instance, bail-in tool can be viewed as expedited version of good/bad bank split, more internalized. Article 2 of the BRRD provides bail-in definition as “mechanism for effecting the exercise by a resolution authority of the write-down and conversion powers in relation to liabilities of an institution under resolution”. The immediate controversy stems from the fact that “the rules stipulate that 8% of a bank’s liabilities must be wiped out before any taxpayer money can be provided” [9]. The resolution authority is exposed to potential claims of discrimination against small minority or subordinated debt holders and not others.
Essentially, based on the President and CEO of the Federal Reserve Bank of Minneapolis, Neel Kashkari[2]:
“Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70 percent. Large banks need to be able to withstand around a 20 percent loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.”
In conclusion, we believe that the mantra of bail-outs is not yet to be totally discounted. However, we are likely to see less of large-scale interventions either by bankruptcy proceedings and liquidations or direct taxpayer involvement to prevent “too big” to fail institutions to actually fail. ‘When in doubt, bail it out’ is still relevant today? It depends! It depends on the level of capital reserves large “too big” to fail institutions are allowed to operate with. Perhaps also it depends on finding the reasons why do we have “too large” to fail institutions in the first place. On a positive note, considerable advances in regularity regimes were and are being implemented globally heading in the right direction. Yet, we have a long way to go.
References
[1] FBS, Key Attributes of Effective Resolution Regimes for Financial Institutions, < http://www.financialstabilityboard.org/2014/10/r_141015/ > [2] https://medium.com/@neelkashkari/jamie-dimons-shareholder-advocacy-letter-c2d867f3cc1e
[1] What Would Happen if Financial Markets Crashed?, The Economist, Leaders Feb 12th 2022 <https://www.economist.com/leaders/2022/02/12/what-would-happen-if-financial-markets-crashed?utm_medium=social-media.content.np&utm_source=linkedin&utm_campaign=editorial-social&utm_content=discovery.content>
[2] Merle R., Taxpayers are still bailing out Wall Street, Eight Years Later, Washington Post November 7, 2016
[3] Vila T. S., Peters M., (2017), “The Bail Out Business: Who Profit from Bank Rescue in the EU?”, Transnational Institute, Issue Brief February 2017
[4] Financial Crisis Inquiry Report, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, pp.551
[5] Baxter Jr, T.C., Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis.
[6] Armour J., Awrey D., Davies P., Enriques L., Gordon J.N., Mayer C., Payne., (2016), Principles of Financial Regulation, Oxford University Press.
[7] Ibid. p.343
[8] EU Bank Recovery and Resolution Directive (BRRD), <https://www.eba.europa.eu/regulation-and-policy/single-rulebook/interactive-single-rulebook/2602>
[9] Brunsden J., Barker A, Bank Turmoil: Are Europe’s New Bail-In Rules to Blame?, FT February 2016
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