Bail-in: Origins & Implementation Wilson Ervin Vice Chairman - PowerPoint PPT Presentation

Bail-in: Origins & Implementation Wilson Ervin Vice Chairman May 2015 This document and the information contained therein may not be reproduced in whole or in part or made available without the written consent of the author. The views contained in this document and presentation reflect those of the author.

The “Great Financial Crisis” caused major d damage . . . . . . exposing a n need f for d deep system r reform Slide 2

Phases of the GFC 1. An asset class crisis (mortgages, esp. USA) 2. Wall St fails – Systemic risk dials go to “eleven” 3. Europe suppresses Phase 2 – but hit by (delayed) “doom loop” 100 80 Equity Volatility (VIX) Phase 2 Systemic Crisis 60 Phase 1: 1: 40 Asset shock 20 Lehman fails 0 Dec-06 Dec-07 Dec-08 Dec-09 TBTF is the key GFC reform Slide 3

Many reforms proposed . . . but one is central Vickers / Liikanen Volcker Rule Basel 2.5, Basel 3, Basel 4 . . . Macro-prudential No Basel Ring-fencing Systemic Regulation Leverage Rules National firewalls (US IHC) Regulatory Consolidation Central Clearing Glass – Steagall Addressing the problem of ‘too big to fail’ is Consumer Protection OTC transparency Subsidiarization the next c central step in the reform program Narrow Banking Compensation Reform New Securities Rules - Mario Draghi Bonus Taxes, Bonus Caps Radical transparency Size curbs – break ‘em up If t the crisis has a s single lesson, , it i is t that the Deferrals, Clawbacks Stop short selling / CDS Board Governance ‘too big to fail’ problem must be solved Liquidity Rules Procyclicality Living Wills - Ben Bernanke Stop Rehypothecation Core Capital Bank Taxes Transaction Taxes Repo Reform Hybrid capital Money Market reform Resolution Funds More Mark-to-market . . . less Mark to market Intrusive supervision Coco’s Resolution / Bail-in Slide 4

So . . . . . . How d do w we actually s solve T TBTF? Slide 5

Some initial proposals to address TBTF 1. Hard-nosed principles – just don’t do bail -outs! 2. Good-bank / bad bank strategies? 3. Forced M&A? 4. Narrow Banking? 5. Break up the big banks? 6. Better regulation – just prevent failure 7. Living Wills? 8. ? Slide 6

Solving the TBTF Puzzle – 4 key pieces 1. Why was Lehman so bad (a.k.a. the missing $100bn question)? 2. How do other industries handle failure? Are banks different? 3. Santa Fe Question: How resilient are the “nodes” of the financial system? 4. Coco initiatives: Flannery, Squam Lake, etc. Slide 7

Too Big T To F Fail? a ( (simplified) example Asset losses (25) Total Assets / 600 Total Liabilities Senior Liabilities Debt, Clients & 550 Counterparties Zero Equity: Pref/ Sub. Debt 25 Insolvency ! Equity 25 Slide 8

Too Big T To F Fail? a ( (simplified) example Bankruptcy Asset loss Losses (25) (+100) 600 Total Assets / Total Liabilities 1. Enormous extra 1. Senior value destruction Liabilities 2. “Replication risk” 2. 550 Bankruptcy Debt, Clients & high ( (correlation Counterparties Estate AND contagion) 3. 3. “Runs” become highly rational 25 Pref/ Sub. Debt 4. 4. System becomes unstable . . . . . . 25 Equity Slide 9

Too Big T To F Fail? a ( (simplified) alternative BEFORE Key E Elements AFTER Asset losses Total Assets 600 (25) 575 1. Separate senior liabilities 1. into “operational” and “Operational “financial” (i.e. term debt) Liabilities” 2. 2. Fast “Chapter 11” recap No change for Clients & 430 430 clients/ customers Counterparties 3. 3. Re Re-cap i investor capital for losses A AND strong new equity (25 25  0  50) 50) 4. Preserve value via “going 4. investors Debt 20% concern” strategy converted to Senior Debt 120 95 equity 5. 5. $ L $ Losses << << liquidation Pref/ Sub. Debt 25 6. No loss o 6. of k key functions Equity 25 50 0 / warrants Slide 10

Bail-in - Adapting “Chapter 11 ” for banking Chapter 11 evolved as a tool to preserve franchise value & continuity 1) Works on the liability side of the balance sheet – restores solvency internally − Single point of control - Avoids need for merger partners, or asset buyers − Not an asset liquidation tool - mitigates ‘fire sale’ discount & pressure on markets 2) Chapter 11: Challenges for Banks: a) Bank failure moves too fast for traditional Chapter 11 legal process b) Unlike other businesses, many bank customer activities occur on the liability side (e.g. deposits, swaps, payments). A strict pari passu process could impair the “franchise” adding significant costs faster than capital was created (e.g. Lehman swap unwind) 3) Bail-in separates “capital structure liabilities ” from “operational liabilities” − Operational liabilities are protected to preserve franchise value & market stability Continuity tools like the 2014 ISDA protocol and x-border recognition are key − Capital structure liabilities convert to new equity via standard Chapter 11 techniques 4) Bail-in uses fast track procedure to preserve confidence and critical functions − Typically includes a Resolution Authority with special legal powers − RRP’s can provide a stand- by “pre - pack” for the RA ( if designed properly) − Solvency, liquidity, and operations need to be clear by Monday morning − Other elements (e.g. precise valuation and allocation) can take much longer Slide 11

Resolution - Rapid Global Progress Special Resolution 2009 Regime (Bridge tool) 2010 Swiss Expert Commission 10% Equity + 9% Cocos 2011 ICB (Vickers) Ring Fence & Bail-in 2012 Dodd Frank “Key Attributes” FDIC adopts SPE Bail-in 2013 Swiss BIO FINMA “SPE Bail -in is primary strategy” Protocol 2014 BRRD / SRM TLAC 2015 Selected countries Slide 12

Common Critiques and Commentary: 1 ) Bail-in is new and untried  Bail-in is built on straightforward Chapter 11 concepts - substantial real-world testing 2) Bail-in will only work for one-off, idiosyncratic bank failures . Bail-in can (& must) work for multi-bank crises (ex ante, we don’t know type of crisis)   Beneficial effects for the system: Provides new equity at the point of failure .  “Nodes” of the financial system become loss -absorbing (not loss-amplifying as in LEH)  3) Bail-in is just a bridge to liquidation or wind down – “resolution is not resurrection” Preservation of going- concern “franchise value” is essential to concept and supports stability  Bail-in internalizes the cost of failure – no need for extra “punishment”?  Liquidation/“ Wind- down” can be chosen by new owners, but should not be imposed  4) Banks fail because of liquidity, not solvency. Bail- in doesn’t address liquidity Chapter 11 recaps typically include both: a solvency program, and a liquidity program   Normally provided by a bank group (DIP financing) after solvency plan is agreed Recapitalized Bank needs to announce a credible liquidity program by “Sunday night”  5) Banks are often quite international with many legal entities. National interests will frustrate Bail-in Bail-in eliminates taxpayer costs, eliminating the dominant political challenge   Secondary concerns can be addressed by clear legal entity strategy (a smart RRP)  Separability is important for MPE banks, but can be counterproductive for SPE firms Internal TLAC important to align national incentives, but design remains a major policy risk  Slide 13

Where are we? One central banker’s view “In short, the US authorities have the technology – via Title II of Dodd F rank; . . . most US banks are . . organised in way that lends them to top-down resolution on a group-wide basis. I don’ t mean it would be completely smooth right now; it would be smoother in a year or two as more progress is made. B ut in extremis, it could be done now . Europe has not reached the same point, but contrary to some commentary is not far behind .” ucker – FSB - Paul T Resolution STC Chair (October, 201 3) Slide 14

Where a are w we? A A m market v view Credit Spreads by Sector  OLA passed in 2010; FDIC adopts SPE Bail-in in in 2012  Tool seen as technically credible & politically essential  TBTF p premium has slowly disappeared – 2014 GAO report unable to discern any remaining market impact in US  Large bank holdco paper seen as fully l loss a absorbing  Europe investor straw poll (2015) 2015):  94% believe bail-in will be used next time  But only 16% feel they know enough to invest intelligently * See Credit Suisse strategy research: US Financial Institutions: Regulatory Reform Impact on Bank Credit Spreads, July 2013, by John Giordano/ Dennis Hannan Slide 15

Bail-in and future crises Eliminating asset shock “fires” is hard  Phase 1 stresses – asset shocks – are hard to foresee reliably and prohibit  Dampening asset markets can lead to other risks – (“meta - risk” a la Minsky) Phase 2 – systemic crisis - is far more destructive Bail-in provides a powerful solution:  Built on established techniques  “Single point of control” simplifies execution  Developed as a “solution” not a “punishment”  Removes government burden (and helps address bank-sovereign feedback problem)  Adds resilience at point of failure  A firebreak against systemic risks Slide 15