Saturday, February 6, 2010

Resolution of TBTF institutions - the "bail-in" solution

Events of the recent past have unequivocally demonstrated the unacceptably high levels of systemic risk posed by the "too big to fail" (TBTF) financial institutions. Accordingly, there is widespread agreement on the need for adequate regulation of these firms and institution of mechanisms that can effectively manage their orderly bankruptcy restructuring when they collapse.

Asset based reserve requirements, contingent capital convertible bonds etc have been some of the more popular regulatory interventions proposed to contain the systemic risk posed by TBTF firms. President Obama's recent Volcker Rule proposal goes further by advocating strict limits on the size and scope of trading activities of the big banks, including banning proprietary trading operations unrelated to serving customers for its own profit.

In an article in The Economist, investment bankers Paul Calello and Wilson Ervin propose an alternative to the unpopular bailouts, in the form of "bail-ins" that would give "officials the authority to force banks to recapitalise from within, using private capital, not public money".

Just before it failed, Lehman’s balance-sheet was under pressure from perhaps $25 billion of unrealised losses on illiquid assets. But bankruptcy expanded that shortfall to roughly $150 billion of shareholder and creditor losses, thereby acting as a loss amplifier. They use the counterfactual of a "bail-in" to explain how it could have allowed Lehman to continue operating and forestalled much of the investor panic that froze markets,

"Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework... officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman’s $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.

The remaining 85% of senior unsecured debt would have been unaffected, as would the bank’s secured creditors and its customers and counterparties. The bank’s previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.

The equity of this reinforced Lehman would have been $43 billion, roughly double the size of its old capital base. To shore up liquidity and confidence further, a consortium of big banks would have been asked to provide a voluntary, multi-billion-dollar funding facility for Lehman, ranking ahead of existing senior debt. The capital and liquidity ratios of the new Lehman would have been rock-solid. A bail-in like this would have allowed Lehman to open for business on Monday...

The new structure would be based on bankruptcy reorganisation principles, allocating value in accordance with investors’ seniority and ensuring that each class of investors would be better off than in liquidation... a lengthy, voluntary process is impractical in the panic surrounding the failure of a very large, complex financial institution... A resolution framework for a large financial organisation must allow a recapitalisation to be implemented much faster than today’s bankruptcy rules allow."

Update 1 (25/4/2010)
As the discussion in the US Senate on the financial market reforms bill gathers pace, Senators Sherrod Brown and Ted Kaufman unveiled a 'SAFE banking Act' with the clear and powerful purpose of breaking up the big banks, especially the six mega banks. The proposal places hard caps on leverage and size of financial institutions.

The bill would cap the amount of non-deposit liabilities of any one bank — effectively, the amount the bank borrows in various ways to finance its operations — at an amount equal to 2 percent of the nation’s gross domestic product, a measure of the size of the economy. For major financial firms that are not banks, like A.I.G., Metropolitan Life or the financial arm of General Electric, the cap would by 3 percent of G.D.P.

The bill would reinforce a 1994 law that bars any single bank from holding more than 10 percent of the nation’s total deposits, or about $750 billion. In the years since then, large firms have obtained waivers or used loopholes in the law to exceed that ceiling. Three institutions — Bank of America, Wells Fargo and J.P. Morgan Chase — are over the limit now, and would have to shed the excess within three years.

In 1995, the assets of the six largest banks were equivalent to 17 percent of G.D.P.; now they amount to 63 percent of G.D.P. Meanwhile, the share of all banking industry assets held by the top 10 banks rose to 58 percent last year, from 44 percent in 2000 and 24 percent in 1990

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