WHO PAYS FOR BANK INSOLVENCY IN TRANSITION AND EMERGING ECONOMIES? David G Mayes Bank of Finland
WHAT IS THE PROBLEM? Too Big to Fail - Too Many to Fail Too Big to Save • Most countries do not have a credible scheme in place that would enable them to close either a large bank or a significant number of banks • Many transition and emerging economies have problems detecting problems before they are large • The problem is even less worked out for complex financial institutions and international banks • If banks are foreign owned then host countries may have little control over what happens
CONSEQUENCES • Potential Moral Hazard • banks may take on greater risks • greater risk of crises • Uneven playing field - restricts competition encourages M&A, increasing the problem • Unfair shift of burden onto • taxpayers • uninsured depositors • some borrowers • society at large • Makes every case political
THREE ISSUES • Why does the problem exist? • How can we assess the costs? • How does our proposal address the problem? David Mayes, Liisa Halme, Aarno Liuksila Improving Banking Supervision Palgrave 2001 David Mayes and Aarno Liuksila Who Pays for Bank Insolvency? Palgrave 2003
THREE ISSUES - issue 1(1) • Why does the problem exist? • Legal issues • practical issues • economic issues • (Not discussing Lender of Last Resort)
THREE ISSUES - issue 1(2) • Why does the problem exist? • Legal issues • Private law vs public law • In most countries private law applies to insolvency so the state cannot decide - not US • Need alignment of interest with deposit insurance (if any) • who pays - taxpayer, other banks (customers/owners)? • If use public law then in danger of being arbitrary • Advancing the priority of the state - as in US • Who has jurisdiction in international banks? • Equal treatment of all creditors/depositors whatever their country • Single entity vs grab for local assets • Conflict of interest - subsidiary may be TBTF but not group
THREE ISSUES - issue 1(3) • Why does the problem exist? • Legal issues • Views differ on balance among stakeholders • owners, managers and creditors, customers near and in insolvency • Banks are different • customers’ income and wealth much more at risk - customers are voters • contagion - direct through failed transactions - debt- deflation - confidence, run on banks, unwillingness to use banks • have to act in hurry • costs of bailout are not obvious, economic downturn is • bank failure equals regulatory failure? State responsible • Procyclicality of regulation and bank behaviour
THREE ISSUES - issue 2(1) • Why does the problem exist? • How can we assess the costs? • Costs in insolvency vs. costs of avoiding it • spreads, bank performance, size and structure of financial sector, economic performance Regulators need to know the cost of their choices includes structure of deposit insurance and implicit guarantees • proper accounting for actual use of funds, subsidies, interest rate effects, discounted values, present value of guarantees etc • is the extent of likely direct contagion overestimated (De Bandt and Hartmann)? • Can the impact on the economy as a whole be properly measured? - what would have happened otherwise? - need to model one course of action against another not just explore growth/GDP residuals - how should the effect on confidence be measured?
THREE ISSUES - issue 2 (3) • Why does the problem exist? • How can we assess the costs? • Costs in insolvency vs. costs of avoiding it • Would wiping the shareholders out ever be too costly? Is the problem simply about where to draw the line among uninsured depositors, creditors and the interbank market? Is there any such thing as too big to fail or too many to fail if the business can be continued? Avoid direct and indirect contagion. • Can adequate valuations be achieved fast enough? Is this simply an accounting/management information problem? How do we balance valuations in the market, fire sale and maximal discounted value? • What is the cost/benefit of moral hazard? Lower spreads for TBTF banks in US (Fitch ratings) Between markets Granlund (2003). Continuous decreased borrowing cost vs occasional bailout? Distortion?
THREE ISSUES - issue 3 • Why does the problem exist? • How can we assess the costs? • How does our proposal address the problem? • Main aim is to provide a credible framework for handling exit to encourage banks to avoid insolvency and encourage the market to solve bank problems early on - without the use of public money except as an ex-post guarantee • Part of a package involving corporate governance changes, improved market information, reduced opportunities for forbearance by supervisors, deterrent penalties • We have tried to address the main issues of rapidity, information, authority, finality and equity in both a national and international environment - loose ends on conglomerates
A FOURTH IMPLICIT ISSUE • When Should the Authorities Intervene? • Part of the process of Prompt Corrective Action • In US intervene when capital ratio falls to 2% • But regulatory capital able to pay out • SKOP bank met regulatory requirements close to failure • Economic insolvency - net worth zero • could pay out all depositors and creditors • Supervisors do not assess net worth • Banks different from other firms • The more they pay out in emergency the bigger the hole gets - get increasingly worse price for assets • Other firms’ assets are pledged so cash-flow insolvency • Act early, banks are worth more alive than dead
THE SCHEME • The authorities take over control of the bank according to prescribed benchmarks. Use public law as US but no special role for deposit insurance fund. No grand institution needed but prior agreement with other countries - panel + treatment of conflict of interest • value assets and liabilities up front and write down the claims to return to operational solvency Respect creditor priority - no one worse of than under insolvency - guarantee new bank - public funds? • reopen for business under new control/ ownership with no material break in operation
WILL IT WORK IN TRANSITION AND EMERGING ECONOMIES? • Vested interests too strong, authorities too weak? • Pressure for delay too strong - problem too large? • Too little transparency - banks, supervisors? • Information too poor - accounting/auditing standards, lack of analysts/ratings, cannot value the bank? • Too little market discipline - no marketed equity or debt - no market for corporate control - insufficient competition for customers? • Irrelevant - banks foreign owned?
STILL AN IMPROVEMENT • Points the system in the right direction • better information, greater transparency, lower moral hazard • Reduces inequity • greater chance those who voluntarily took risks pay • earlier action, smaller problem • More prudential banking system • smaller risk of crises • Consistent with Basel Committee
TIMING IS CRUCIAL • If banks are weak introduction triggers a crisis • Needs to be part of framework - crucial role for deposit insurance with matching incentives • Unfortunately history suggests that the next crisis will be necessary to get the next round of regulatory change