Re-establishing Market Discipline and Reducing Taxpayer Burden: Will Bail-in Do the Job?

Transcription

1 Re-establishing Market Discipline and Reducing Taxpayer Burden: Will Bail-in Do the Job? George G. Pennacchi Department of Finance University of Illinois Financial Safety Net Conference 2015 Stockholm 20 May 2015

2 The Failure of Subordinated Debt During the Crisis Just before the financial crisis, policymakers stated that banks were well-capitalized. For example: Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy. Ben Bernanke, 15 Oct 2007 Speech to the Economic Club of New York. In part, this view presumed that subordinated debt capital would absorb losses ahead of public taxpayers. However, large and widespread bank losses, along with the complexity of resolving multiple large bank failures, led to public capital injections that protected subordinated debt from losses.

3 Market Discipline Prior to the Crisis There is evidence that, prior to the crisis, credit spreads on a bank s subordinated debt reflected its default risk.* But market discipline was less than complete for large banks: The relationship between a bank s credit rating and its bonds credit spreads was weaker for TBTF banks.** The difference between a bank s overall credit rating and its rating based on intrinsic financial strength ( uplift ) was greater for larger banks, indicating TBTF expectations.*** Banks with greater ratings uplift took more risk prior to the crisis.**** * Flannery, M. and S. Sorescu (1996) J. Finance ** Morgan, D. and K. Stiroh (2005) FRBNY Staff Reports, no. 220 *** Rime, B. (2005) Swiss National Bank working paper. ****Alfonso, G., J. Santos, and J. Traina (2014) FRBNY Econ. Policy Rev.

4 Bail-in, Taxpayer Burden, and Market Discipline Ceteris paribus, bail-in resolutions should reduce the likelihood of a taxpayer funded bailout by identifying: a resolution entity, such as a parent or holding company, that allows material and foreign subsidiaries, such as a depositissuing bank, to continue critical functions. specific types liabilities that legally qualify to be bailed-in (written down or converted to new equity) without triggering bankruptcy. a minimum of total loss-absorbing capacity (TLAC) liabilities sufficient to absorb all losses, thereby protecting taxpayers. Supervisory authorities find bail-in attractive because it simplifies large bank failures, reduces taxpayer exposure, and potentially improves market discipline.

5 Concern I: When Will Supervisors Intervene? The FSB key attribute Resolution should be initiated when a firm is no longer viable or likely to be no longer viable is vague. Determining the point of non-viability (PONV) might be difficult: bail-in at the holding company could protect a deposit-issuing bank subsidiary and eliminate runs by wholesale depositors. but uninsured depositor runs are the form of market discipline that often forces timely intervention by supervisors.* Determining the PONV by regulatory capital ratios has flaws: banks may under-report Basel risk weights and trading book risk when they have lower equity capital.** regulatory capital ratios are slow to reflect problems. * Bennett, R., V. Hwa, and M. Kwast (2014) FDIC CFR working paper ** Mariathasan, M. and O. Merrouche (2014) J. Finan. Intermediation and Begley, T., A. Purnanandam, and K. Zheng (2015) LBS and U. Michigan working paper.

6 Tier 1 Regulatory Capital During the Crisis Crisis banks (No crisis banks) received (did not receive) government support. Source: A. Haldane (2011) Capital Discipline, Bank of England working paper.

7 Market Value of Capital During the Crisis Banks market capitalization to book-value of debt. Source: A. Haldane (2011) Capital Discipline, Bank of England working paper.

8 Concern I: When Will Supervisors Intervene? (continued) In addition to difficulties measuring the PONV, a systemic crisis during which multiple G-SIBS require resolution might delay intervention.* The danger from intervention delays is that losses can mount to extraordinary levels and exceed TLAC. Under bail-in, supervisors may need to rely more on market signals of financial distress, such as a bank s market value capital ratio or the credit default swap spread on its bonds. It may be prudent to require intervention when a market financial ratio breaches a threshold unless supervisors explicitly vote to waive the requirement. * Skeel, D. (2014) U. Pennsylvania Law School Faculty Scholarship Paper 949

9 Concern II: Division of New Equity at Resolution The resolution authority needs to determine how to divide new equity shares among the bail-in-able senior unsecured, subordinated, and equity investors of the resolution entity. To enhance market discipline by removing regulatory uncertainty, the allocation should respect investor seniority and abide by the no creditor worse off principle. After a period of financial disclosure (1-3 months), a marketoriented allocation (c.f., Bebchuk, 2000) might occur where:* 1) equity investors have the option to purchase all new equity for the par value of all senior and subordinated claims.** 2) If they decline, subordinated investors have the option to purchase all new equity for the par value of senior claims. 3) If they decline, senior investors own all of the new equity. * Bebchuk, L. (2000) European Econ. Review ** Option rights could be sold to any (deep-pocketed) investor.

10 Concern III: Does Bail-in Improve Incentives? Bail-in should make yields on senior and subordinated debt of the resolution entity more sensitive to default risk. But since bail-in-able debt must be longer maturity so that only a proportion matures and is reissued each period: the market discipline in terms of a higher interest penalty arising from greater risk can be small in the short run. if the bank suffers a sudden large loss in asset value, there will be risk-shifting incentives to raise asset risk* and debt overhang disincentives to replenish the lost equity.** It is bail-in-able debt s loss absorbing qualities that, during a crisis, creates risk-shifting incentives and debt overhang. * Jensen, M. and W. Meckling (1976) J. Finan. Econ. ** Myers, S. (1977) J. Finan. Econ.

11 Potentially Better Market Discipline: Going-Concern CoCos Equity investors moral hazard incentives are eliminated if the bank issues nearly risk-free CoCos that do not absorb losses. Going concern CoCos that, when triggered, would heavily dilute shareholders and benefit CoCo investors instill incentives to avoid risk-shifting and to replenish equity after an asset loss. But CoCos issued thus far possess conversion terms that benefit equity investors and harm CoCo investors because many require write-downs of CoCos from their par value. others convert to new shares that are likely to have a market value much below the CoCo s par value.* Also, while existing CoCos have high regulatory capital triggers, they are likely to convert only after the bank is a gone-concern. * Berg, T. and C. Kaserer (2015) J. Finan. Intermediation

12 Complementary Securities that Avoid the Need to Bail-in Requiring CoCos with a market value of equity trigger that heavily dilutes shareholders (and benefits CoCo investors) upon conversion instills incentives to avoid financial distress.* A similar call option enhanced reverse convertible (COERC) provides equity investors with the option to repay CoCo investors at par upon conversion, thereby protecting equity investors against potential stock price manipulation.** These CoCos with market value of equity triggers are designed to convert well-before the PONV, and current research finds that they are robust to many earlier criticisms of securities having market value triggers.*** * Calomiris, C. and R. Herring (2013) J. Applied Corp. Finan. ** Pennacchi, G., T. Vermaelen, and C. Wolff (2014) J. Financ. Quant. Anal. *** Pennacchi, G. and A. Tchistyi (2015) U. Illinois working paper.

13 Conclusions A bail-in resolution improves upon the pre-crisis policy of requiring bankruptcy in order for subordinated debt to absorb losses. A bail-in policy can utilize market information to: 1. trigger timely intervention by the resolution authority. 2. fairly allocate new equity shares to various investor classes of the resolution entity. But much more can be done to avoid situations where bail-in would be needed. Requiring that banks issue CoCos that do not absorb losses because shareholders are heavily diluted at conversion creates the greatest market discipline for avoiding financial distress.