the case for bail-ins · the case for bail-ins: summary too big to fail is too costly to continue...

The Case for Bail-insDr. Thomas F. HuertasInstitute for Law and Finance

Frankfurt

3 May 2012

The case for bail-ins: summary

► Too big to fail is too costly to continue► Bail-ins are superior to bail-outs

► Bankruptcy doesn’t work for banks► Bail-ins may be superior to insolvency/liquidation

► Banks need a special resolution regime

► How Private Markets Have Solved Similar Problems

► How Bail-in Could Work► For groups organized as holding companies

► For unitary banks

� Conclusions

03 May 2012Page 1 [Presentation title]

Too big to fail is too costly to continue

� bail-outs strain the public finances

� bail-outs distort competition

� bail-outs undermine market discipline

� bail-outs are not an option

03 May 2012 [Presentation title]Page 2

Bankruptcy doesn’t work for banks

� banks cannot operate whilst in insolvency

� liquidation destroys value and diminishes the recovery that creditors can make

� for systemic banks liquidation would have large adverse knock-on effects on financial markets and the economy at largelarge

03 May 2012 [Presentation title]Page 3

Banks need a special resolution regime

� To avoid bail-outs and to avoid liquidation banks need a special resolution regime.

� This empowers the resolution authority to intervene at the point where the bank no longer meets threshold conditions and to employ the tools in its “resolution tool kit” to resolve the bank in a manner that the bank in a manner that

� Does not require taxpayer support for the bank’s solvency; and

� Does not result in significant social costs (disruption to financial markets, reductions in output and employment)

� The first question is whether bail-ins should be in the tool kit at all.

� If so, when should the resolution authority utilise the tool?

03 May 2012 [Presentation title]Page 4

What tests does bail-in need to meet?

� bail-in must be better than bail out

� bail-in must be better than insolvency/liquidation

� bail-in must be workable

But But

� bail-in need not be the only solution

� bail-in can be used in conjunction with other tools

03 May 2012 [Presentation title]Page 5

Banks have used bail-in to solve similar problems in private markets

� Securitization structures are designed to avoid bankruptcy.

� Securitization structures effectively bail-in junior creditors in reverse order of seniority as cash flows dry up.

� Securitization structures are

Super-Senior

Cash flowfrom assets

© 2012 Huertas Risk and Reward6

� Securitization structures are designed to go into solvent wind-down if asset and liquidity tests are not met.

Stub

Senior

Equity

�What should a solution involving bail-ins deliver?

� continuity of critical economic functions� This minimises social cost.

� This requires that the institution in resolution have access to adequate liquidity. Bail-in will not produce a “Lazarus effect”.

� no taxpayer support for solvencyThis eliminates drain on the public finances. � This eliminates drain on the public finances.

� sufficient certainty with respect to process that authorities will employ in resolution with respect to each element in the capital stack to enable investors to estimate loss given resolution� This helps assure that the bank can issue the instruments that will

be subject to bail-in.

© 2012 Huertas Risk and Reward7

How bail-in could work

intervention

Resolution authorityevaluates options

Home-host cooperation is

vital

ExecuteBail-in

COB Friday MondayAsia open

Recovery

Deposit transfer/Bridge bank

Subsequent “month”

Sale

Bail-in via conversion at unitary bank

Deposits Deposits

Formerly senior obligations acquire predominant share

in new equity

Distribution of new common

equityamong old providersof investor

capital

Liability structureprior to intervention

Liability structureafter conversion

Other debt Other debt

NewCommon

equity

Commonequity

Non-core Tier 1

Senior debtSubject to bail-in

Tier 2

Old common

equity suffers

‘death bydilution’

CommonEquityAfter Writedown

How bail-ins could work: holding companies and the “single point of entry”

Parent holding company

Global source of strengthdoctrine?Based on structural subordination of holdingcompany debtLiquidity?

Domesticbank

Domestic subsidiaries

Foreignsubsidiaries

Foreign subsidiaries

03 May 2012 [Presentation title]Page 10

Conclusions

� bail-ins are superior to bail outs

� bail-ins are superior to liquidation

� bail-ins may be an effective resolution tool. They merit inclusion in the resolution tool kit under a special resolution regime.

� some key questions remain� How to assure that there will be outstanding an amount of instruments subject to � How to assure that there will be outstanding an amount of instruments subject to

bail in sufficient to recapitalise the institution whilst assuring continuity of critical functions

� Treatment of foreign branches and subsidiaries/cooperation among authorities

� Provision of liquidity to institution in resolution

� How to restore the institution post bail-in to private investor control/exit from resolution/constraints on discretion of resolution authority

03 May 2012 [Presentation title]Page 11

Thank you