CRISIS RESOLUTION IN FINANCIAL INSTITUTIONS: THE EXPERIENCE FROM RECENT CRISES

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1 IJER, Vol. 10, No. 1, January-June, 2013, pp CRISIS RESOLUTION IN FINANCIAL INSTITUTIONS: THE EXPERIENCE FROM RECENT CRISES CLAS WIHLBORG Chapman University, One University Drive, Orange, CA 92866, United States, and Copenhagen Business School, Department of Finance, Solbjerg Plads 3, DK-2000 Frederiksberg, Denmark. FINN OSTRUP Copenhagen BusinessSchool, Center of Financial Law, Solbjergvej 3, 2000 Frederiksberg, Denmark, LARS OXELHEIM Lund University, Institute for Economic Research, P. O. Box 7080, S , Sweden, and The Research Institute of Industrial Economics, P.O.Box 5565, Stockholm, Sweden, ABSTRACT The article examines procedures for handling crises in financial institutions. The article first sets out considerations which are important in the design of a strategy for handling crises in financial institutions. The article next presents the main arguments concerning the different methods which have been used hitherto and briefly sums up the experience from recent financial crises concerning these methods. The current financial crisis has demonstrated that the authorities are unwilling to allow financial institutions to fail. This is also the experience from other recent financial crises, e,g. the crisis in the Nordic countries in the 1980s and the 1990s and the Japanese crisis. This raises doubt about the realism of current policy proposals which imply that financial institutions should be wound up. As an alternative resolution mechanism, it is argued that the authorities should use a procedure which involves a reduction of debt in the failing institution. This could most conveniently be achieved through a procedure which allows for the conversion of debt into equity. JEL CODES: D53, E44, E58, F55, G01, G18, G21, G28. KEYWORDS: Financial crisis, Crisis resolution, Insolvency procedures, Financial crisis management. 1. INTRODUCTION Since mid-2007 many financial institutions have experienced crises, implying that capital has fallen below the minimum required by the authorities. A crucial question

2 158 Clas Wihlborg, Finn Ostrup & Lars Oxelheim is the best way to proceed when the authorities are confronted with such crises. This problem is currently addressed by the authorities in a large number of countries, notably the European Union and the United States. The authorities seem to converge on a crisis resolution procedure which in the future will allow for the failure of financial institutions, implying that the financial institution is wound up according to a procedure laid down in legislation. It is argued in this article that this resolution procedure is unrealistic for many reasons, not least because it runs counter to political interests. The experience from the current and also from previous financial crises demonstrates that the authorities have been unwilling to wind up financial institutions. As an alternative crisis resolution procedure, the article suggests a reduction of debt in a failing institution and, in particular, to allow for the conversion of debt into equity. Another possibility is to continue the activities of the failing institution in a subsidiary to which assets and some liabilities are transferred. How to proceed in the case of collapses in financial institutions has been discussed in a large literature. Many writers share the view that financial institutions should be allowed to fail. 1 An important consideration in the literature is the question of moral hazard. The failure of financial institutions is seen as an efficient way to discourage actors in the financial sector from engaging in future risky transactions. The article first sets out the main considerations which are important in the design of a strategy for handling crises in financial institutions. It is argued that a crisis resolution procedure should be not only economically efficient in the sense of meeting various economic considerations. It should also be politically feasible in the sense that policy makers should be willing to implement the solution when a financial crisis has broken out. The article next presents the main arguments concerning the winding-up of financial institutions and considers the experience gained from financial crises concerning this and other crisis resolution procedures. The article finally turns to the question of the best resolution procedure. 2. ECONOMIC CONSIDERATIONS ASSOCIATED WITH HANDLING CRISES IN FINANCIAL INSTITUTIONS It complicates the handling of banking crises that a number of different considerations, working in opposite directions, should be taken into account to make a crisis resolution procedure economically efficient. As a first consideration, the interests of the different parties involved in the institution should be taken into account. This is also the case in an ordinary company failure. Thus, proper protection must be accorded to creditors who should be shielded from further losses in connection with a continuation of the loss-making activities of the company. In the ordinary bankruptcy procedure, this consideration is met by transferring the power of running the company from the shareholders to debt holders, making it possible for debt holders to discontinue the loss-making activities of the company and also protecting debt holders against owners engaging in risky activities to recoup previously incurred losses.

3 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 159 Single debt holders must be protected from the risk that other creditors may try to avoid losses by withdrawing assets from the distressed company. In the ordinary bankruptcy procedure, this consideration is met through a freeze on the withdrawal of funds from a failing institution. In financial institutions a freeze on the withdrawal of funds may be difficult to apply as liabilities are usually short term. If there are rumours about impending difficulties, there may be a run on the financial institution. Furthermore, in financial institutions, a freeze on the withdrawal of funds may cause large costs as debt holders may count on the funds held with the financial institution for future transactions. Depositors may, for example, count on the deposits held with banks to make future payments. Proper protection should also be accorded to owners. This is especially important in the case of financial institutions in which owners usually have little possibility to influence the management of the company. Legal and other direct costs in connection with failures in financial institutions should be minimised as far as possible. Due to the numerous relations between financial institutions and other parties, a collapse in a financial institution may lead to a chain reaction with failures in other financial institutions and non-financial enterprises which become unable to make payments. The direct costs associated with failures in financial institutions may therefore be particularly large. It further complicates the handling of crises in financial institutions that financial activities give rise to various external effects. Thus, due to the frequency of transactions with a financial institution and the difficulties related to assessing its financial situation, investors with surplus funds should be able to invest the funds in a financial institution without incurring costs related to assessing the solvency of the institution. In particular, a case exists for giving protection to investors who use deposits for payments transactions. Moreover, in a world of asymmetric information, a case exists for avoiding a disruption of relations between financial institutions and borrowers so as to maintain credit. An additional consideration to be taken into account in the handling of financial crises is to maintain competition in financial markets. A characteristic feature of financial markets is a high degree of concentration which limits competition. Against this background, it can be seen as undesirable if financial crises cause a further rise in concentration. Financial institutions which have suffered losses due to, for example, mistakes in the evaluation of projects may otherwise be efficient in their activities, making it inefficient to merge them with other financial institutions. To the extent that losses in financial institutions are due to factors which are within the control of company managements, e.g., losses caused by high-risk business strategies, it is desirable that crises are handled in such a way that it provides company managements with a disincentive to engage in future transactions that involve a high degree of risk. In other words, a goal of crisis management should be to counter moral hazard. Moral hazard can be avoided, or reduced, by punishing those

4 160 Clas Wihlborg, Finn Ostrup & Lars Oxelheim responsible for collapses in financial institutions. This speaks in favour of solutions in which costs are levied upon executive officers, external and internal auditors, nonexecutive directors and other executive staff who bear a responsibility for the strategies that have led to the corporate failure. It may also be seen as appropriate that shareholders who have the power to select the management, are punished. If moral hazard is not countered, a misallocation of resources will result caused by the incentive to take excessive risks. Stern and Feldman (2004) argue that such a misallocation of resources will cause substantial social costs. 2 An incentive for risk-taking in financial institutions may also cause costs in association with a rise in economic fluctuations. As a final aspect, it can be seen as appropriate if a crisis resolution procedure brings the general economy closer to a new equilibrium. In practice, this implies that the crisis resolution procedure should work to reduce debt. Thus, many financial crises, including the recent crisis, have been characterised by prior speculation financed through a rise in lending. When asset prices fall, the economy is left with a large debt burden. As debtors subsequently try to rebuild their wealth, this debt burden may, for a prolonged period, restrain private consumption and investment. In order to prevent such prolonged periods with low demand and growth, it is optimal that the crisis resolution procedure reduces the overall debt burden in the economy. 3. POLITICAL CONSIDERATIONS IN THE CHOICE OF CRISIS RESOLUTION PROCEDURE Besides meeting economic considerations, it is important that a crisis resolution procedure should be politically feasible. By political feasibility, we understand that the crisis resolution procedure is designed in such a way that the temptation of policy-makers to overrule the procedure is minimised. One condition for political feasibility is that the crisis resolution procedure is time consistent, implying that the solution preferred by policy makers in the short term collides with the procedure that is optimal from a long-term perspective. If the short-term optimal situation differs from the long-term optimal solution, policy makers have an incentive to choose the short-term solution due to a short time horizon, e.g., caused by the desire of policy makers to be re-elected. Another condition for political feasibility is that the losses incurred by financial institutions are distributed in a way which is seen as equitable by the general public. Losses arise from transactions which have been conducted in the past. These losses can be borne by four parties: (i) they can be borne by the owners of the financial institution who may experience a fall in the value of their equity, (ii) they can be borne by the creditors in the financial institution, including depositors, who may experience a write-down of their claims, (iii) they can be borne by customers who may experience a rise in the price of financial products in the form of higher fees, lower interest rates on deposits, and/or higher rates on loans, and/or (iv) they can be borne by the

5 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 161 government or by the central bank which may finance the losses through the public budget and/or by expanding the money supply. It is generally seen as fair if losses are borne by the owners of the failing company. The owners are, after all, responsible for the management of the company and therefore for the losses which result from failed projects. Furthermore, the probability of losses should be reflected in share prices, implying that shareholders receive compensation for the risk. It also seems to be a widely held view that it is unfair if losses are borne by depositors, especially by small depositors. Depositors are usually unable to assess the solvency of a financial institution and, for this reason, it is seen as unjust if they are to experience losses in connection with a failure in a financial institution. Furthermore, depositors may have placed a large share of their wealth in the financial institution, causing a disproportionate large loss if the institution fails. It is usually seen as unfair if households in this way experience serious difficulties. The distribution of losses on the ground of fairness should not be seen as a new task for the authorities. It has traditionally been the task of policy makers, through regulation and through public transfers, to bring fairness to the economic system. This also applies to financial crises. Neither should the protection of depositors be seen as a new task for governments. It has traditionally been a task for governments to provide the public with stores for wealth which offer investors a reasonable degree of certainty for future consumption. Historically, this has been achieved through the issue of legal tender. The value of the legal tender was previously maintained through rules which restricted its supply, e.g., rules which required the convertibility to gold. In more recent times, the authorities have considered it a goal to maintain the real value of savings through monetary policies directed towards low inflation. 4. ADVANTAGES ASSOCIATED WITH THE WINDING-UP OF FINANCIAL INSTITUTIONS Six different crisis resolution procedures have been used for managing crises in financial institutions: (i) the financial institution is wound up on the basis of the rules which are laid down in the legislation, possibly according to a special procedure for financial institutions, (ii) the authorities refrain from intervention in the expectation/ hope that losses can be covered through future earnings in the crisis-ridden financial institution (regulatory forbearance), (iii) the financial institution is reconstructed by raising new equity in the financial markets, (iv) the financial institution is merged with another financial institution, (v) the financial institution is rescued through the injection of public funds, possibly being taken over by the government or by other public bodies, and (vi) the financial institution is reconstructed through a reduction in outstanding debt. After the recent financial crisis, a consensus has formed on the view that solution (i) that is, the winding-up of financial institutions should be preferred. In Britain, a

6 162 Clas Wihlborg, Finn Ostrup & Lars Oxelheim special resolution procedure was established with the Banking Act of One element in this resolution procedure was to establish a new bank insolvency procedure with the aim of facilitating the winding-up of failing financial institutions. In the United States, the recently adopted Dodd-Frank Wall Street Reform and Consumer Protection Act contains a resolution regime under which federal regulators can seize any financial company whose failure threatens the financial stability. In October 2009, the European Commission presented a communication on cross-border crisis management in the banking sector. 3 The basic message in the communication is that financial institutions should be allowed to fail. 4 Meeting in December 2009, the EU Economics and Finance Ministers stated it as the goal of crisis management procedures to limit public intervention so that it should always be possible politically and economically to allow banks to fail, whatever their size. The authorities have worked to make the failure of financial institutions more acceptable seen from an economic and political perspective. Deposit guarantee schemes have been improved, implying that depositors are better protected against losses in connection with failures in financial institutions. Several countries e.g., Britain and Denmark have adopted special resolution procedures which imply a swifter, and thus more efficient, procedure for dealing with failed institutions. Countries have also called for financial institutions to draft living wills, i.e., plans for the winding-up of institutions in crisis situations. Many factors support the use of a resolution procedure which involves that financial institutions are allowed to fail. First, the winding-up of distressed financial institutions is efficient in countering moral hazard. Thus, losses fall on the company owners who control the company. Also others with a responsibility for the failure are usually punished. For example, employees often lose their jobs. Second, the winding-up of distressed financial institutions improves resource allocation. Thus, by being exposed to the risk of failure, financial institutions are treated in the same way as non-financial corporations which face a bankruptcy risk. If financial institutions were to be accorded special treatment in the form of a guarantee against failure, a misallocation of resources would result in favour of financial activities. The outcome would be a financial sector which is too large seen from a social perspective. It further supports a crisis procedure involving the winding up troubled financial institutions, that if one allows for the possibility of rescuing distressed financial institutions, such rescue operations may be used especially in support of large institutions which are too big to fail. Such an advantage accorded to large institutions causes a dislocation of resources between large and small financial companies and prevents competition. Empirical investigations indicate that the consideration to gain advantages from being too large to fail is an important motivation behind mergers in the financial sector. 5

7 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 163 As a fourth factor in support of allowing financial institutions to fail, the procedures for dealing with failing institutions imply that management loses the control over the institution either to the authorities or to creditors. This can be seen as efficient because it implies a discontinuation of the loss-making strategy which has pursued by the failed institution. In addition, the various procedures freeze assets in the institution, protecting creditors from the withdrawal of other creditors. It further speaks in favour of allowing financial institutions to fail, that the procedure may lead to an ultimate write-down debt in the case that the revenue from the sale of assets is insufficient to cover claims. The economy is thus brought closer to a new equilibrium with a lower debt level. As a final factor in support of winding up distressed financial institutions, one may see it as equitable that losses in connection with financial activities fall on those investors who are able to control the corporation and who could therefore have taken steps to avoid the losses, that is, in particular the owners. As mentioned above, it adds to the political legitimacy that depositors are protected through deposit guarantee schemes. 5. THE EXPERIENCE FROM RECENT CRISES: THE WINDING-UP OF FINANCIAL INSTITUTIONS In spite of the perceived advantages related to the winding-up of financial institutions which were discussed above, the experience from the recent financial crisis and from previous crises demonstrates that the authorities refrain from using the procedure. During the recent crisis, we find in the European countries only two cases of financial institutions which have been allowed to fail according to a normal procedure which involves losses for creditors. In the Netherlands, the small DSB Bank was allowed to fail and creditors have suffered losses. In Iceland, the three large Icelandic banks were treated according the standard bankruptcy procedure laid down by Icelandic legislation. The bankruptcy procedure in Iceland was, however, only brought into action after deposits were transferred from the failed banks to new banks which were established by special legislation. In the case of the United States, the winding-up of distressed financial institutions has been used to a larger extent. It is, however, noteworthy that, with the exception of Lehman Brothers, the procedure has only been used for smaller financial institutions while larger banks have been saved through the injection of public capital or the merger with other banks. 6 The authorities unwillingness to let financial institutions fail during the recent crisis is surprising because, prior to the crisis, a consensus seemed to form both in the academic literature and among policy makers that it would be most efficient to let financial institutions fail, possibly according to a special procedure which would facilitate the process. Thus, when the current crisis broke out in August 2007, many policy makers and central bankers pronounced in favour of letting distressed financial institutions fail. Many countries had governments which adhered to liberal

8 164 Clas Wihlborg, Finn Ostrup & Lars Oxelheim principles, most importantly the Bush administration in the United States. It might have been expected that these governments would refrain from intervention in the financial sector, allowing troubled financial institutions to fail. Prior to the crisis, several writers proposed procedures which would make the winding-up easier to practice. 7 Prior to the current crisis, in several countries there were deliberations on how to proceed in the case of a new crisis. The outcome of these discussions was to suggest solutions which would allow financial institutions to fail. In Sweden, a government committee published in 2000 a report on the best way to handle bank crises. 8 The conclusion was that banks without a long-term potential for survival should be allowed to fail while banks with a long-term potential should be taken under public custody to allow for a reconstruction. In 2003 the Swedish central bank (Sveriges Riksbank) set out its views concerning its role as lender of last resort. 9 Liquidity would be provided for banks with a systemic importance to the general economy but only if the bank was solvent. A collapse in one of the four largest Swedish banks should not, according to the Swedish central bank, be seen as an event of systemic importance. It would, however, qualify as an event os systemic importance if all of the four largest Swedish banks collapsed. The recent crisis has demonstrated that the authorities are willing to go far in their protection of creditors. It is noteworthy that depositors in even small financial institutions have been saved. One example is the rescue of Northern Rock in which depositors were saved by the government even though many of the depositors were attracted to Northern Rock by high deposit rates which might have made them suspicious with respect to the risk involved with placing deposits in Northern Rock. Another example is the rescue operations performed by the British and Dutch governments to the benefit of depositors who had placed in Icesave, the internet arm of the Icelandic bank Landsbanki. Again, depositors had been attracted by high interest rates. It may be argued that they had deliberately run a risk by moving funds to internet accounts offered by an Icelandic bank. The experience from the recent financial crisis of the authorities being reluctant to wind up troubled financial institutions corresponds to previous crises. Despite being the procedure envisaged in financial legislation, the winding-up of distressed financial institutions has been little used. Thus, during the Norwegian financial crisis in the 1980s and the 1990s, only one financial institution was wound up according to the procedure laid down in the Norwegian financial legislation, and during the Swedish crisis only one company a small insurance company underwent formal bankruptcy proceedings. In Finland, one bank was split up and sold to other banks. The same goes for the Danish financial crisis at the end of the 1980s and the beginning of the 1990s when only seven banks underwent bankruptcy proceedings out of a total of 53 bank failures. The crisis in the Nordic countries was solved through a mixture of mergers and the use of public funds and guarantees. The same picture emerges from

9 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 165 the Japanese financial crisis during which bank failures were solved through mergers and the injection of public funds. Important economic factors help to explain the unwillingness of the authorities to let financial institutions fail. First, the authorities have feared the reaction of the markets to a failure in a financial institution. Thus, when the U.S. government on September 15, 2008 decided to let Lehman Brothers file for bankruptcy, a sharp market reaction followed in the form of a rush to safe placements and a sharp rise in risk premia. This rush to liquidity following the collapse of a bank is not a unique event. Following the bankruptcy in June 1974 of the medium-sized German Bank, Bank Herstatt, banks all over the world reacted by cutting credit lines to other banks and there was a significant rise in risk premia. In November 1997, the small Japanese broker firm Sanyo Securities collapsed. The Bank of Japan considered Sanyo Securities as having no systemic importance and allowed the firm to go into bankruptcy. Japanese banks reacted with a large reduction in lending via the interbank market and there was a marked increase in risk premia. Second, the authorities have been reluctant to impair existing financing channels by allowing a financial institution to fail. This has been especially important during the recent financial crisis when there was a reduction in credit availability caused by the collapse in markets for asset-backed securities. The international integration of financial markets has worked to make national authorities less willing to let financial institutions go into bankruptcy. National authorities may fear a withdrawal of foreign capital from the domestic financial sector if they allow losses in a domestic financial firm. In the international macroeconomics literature, a number of investigations have been undertaken concerning what has become known as sudden stops, i.e., the sudden reversal of cross-border capital flows. 10 The sudden capital outflow from Thailand in July 1997 was precipitated by the collapse in the financial company, Finance One. In July-August 2008, the Danish authorities stepped in with guarantees for the debtors in the medium-sized Danish bank, Roskilde Bank, with the explicit goal to avoid a withdrawal of foreign funding from Danish banks. Political considerations also seem to have played an important role in deciding not to let financial institutions fail. As discussed above, policy makers see it as their role to bring about a fair distribution of losses, implying that they face a strong pressure for rescuing creditors in failing financial institutions. The political difficulties associated with allowing financial institutions to fail can be illustrated by an example from the Danish financial crisis at the end of the 1980s. A small Danish bank (6. Juli Banken) had collapsed in Denmark at the time had no deposit guarantee scheme. In a television interview, the Chairman of the Danish Bankers Association argued that the losses related to the bank crash should be borne

10 166 Clas Wihlborg, Finn Ostrup & Lars Oxelheim by shareholders and debt holders, including depositors. Depositors should have been suspicious that the bank might collapse as they had been offered high interest rates in an attempt by the bank to attract funds. Thus, according to the Chairman of the Bankers Association, it was the depositors own fault that they were to suffer losses from placing in the failed bank. Therefore, intervention to cover the losses of depositors was unwarranted. Neither was there a need in Denmark to establish a deposit guarantee fund as this would increase the problems related to moral hazard. After the Chairman s statement, into the television studio was unexpectedly brought an invalid person who had just, two days prior to the collapse of 6. Juli Banken, placed a large invalidity indemnity in the failed bank. The Chairman of the Danish Bankers Association was asked whether he found it fair that this person should experience a drastic reduction in his future living standard because the bank had collapsed. The Chairman of the Danish Bankers Association maintained that this should be so. During the next days, the Danish newspapers campaigned vigorously that the invalid person should be allowed to keep his means of existence. Influenced by this pressure, the government proposed shortly afterwards the creation of a deposit guarantee fund. The Danish government also exerted pressure on the Danish banks to cover all losses related to the collapse of 6. Juli Banken. The invalid kept his invalidity indemnity. The episode shows that, in spite of economic arguments, it is difficult for a government to allow ordinary investors to lose from failures in financial institutions. There will always be examples of investors who are treated in a way that is seen as unfair by the general public and thus by voters. It further speaks in favour of rescuing financial institutions that it represents a politically safe solution. In the short term, benefits are derived from a reduction of uncertainty in the financial sector and through a continued access to credit while the costs in the form of inefficient resource allocation, a higher level of concentration, and/or larger public expenditure will only show up in the longer term. Furthermore, by rescuing failing financial institutions policy makers can derive a political advantage by being able to display a capacity to act. Governments who stand back and who refrain from intervention may be seen as weak. During the recent financial crisis, many governments, e.g., the British government, experienced a boost in opinion polls due to their intervention to rescue of financial institutions. For example, Prime Minister Gordon Brown received broad backing from his intervention to make Lloyds Banking Corporation take over the troubled HBOS. As a further political factor, the authorities unwillingness to let financial institutions fail during the recent crisis may be explained by credit playing a larger role for ordinary households, and thus voters, than previously. Households in the old industrial countries have become increasingly dependent on credit. The dependence of households on credit has also increased the political interest in avoiding a sudden stop of credit flows. During the recent crisis, the risk of credit restraint was seen as the major threat which necessitated the rescue of financial institutions.

11 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 167 There has further been a tendency towards households obtaining finance through floating rate loans with the interest rate being tied to a short-term interest rate. This makes households more dependent on fluctuations in the interest rate. This in turn increases the political interest in maintaining a low short-term interest rate and thus also to avoid the rise in risk premia which could follow if creditors experience losses in connection with failures in financial institutions. The stronger dependence of households on credit contrasts with the situation of non-financial enterprises which in most countries have seen a reduction in debt relative to non-disposable income. Non-financial enterprises have now at their disposal a larger number of possible channels through which they can raise finance, implying that they have become less vulnerable to the sudden stop of credit which may follow from the failure of financial institutions. Thus, due to the development of securities markets, non-financial enterprises can raise finance more easily through stocks and corporate bonds. Due to international financial integration, non-financial enterprises can also raise finance from foreign sources, e.g., foreign banks. Given the lesser dependence on credit and the larger number of financing sources available to non-financial enterprises, it is now less likely that the failure of financial institutions will cause non-financial enterprises to react with a cut-back in corporate investment. 6. THE EXPERIENCE FROM RECENT FINANCIAL CRISES: OTHER CRISIS SOLUTIONS It has been discussed above that the experience gained from the recent and from previous crises discourages the winding-up of distressed financial institutions as a method to deal with crises in financial institutions. Problems arise, however, also from other of the resolution mechanisms which were mentioned above, especially procedures (ii)-(v). Thus, with respect to solution (ii) mentioned above, i.e. regulatory forbearance, broad agreement exists that this solution should be avoided. In arriving at this conclusion, writers have pointed to the experience of the Japanese financial crisis and the experience of the U.S. Savings and Loan Crisis. Even though there have also been experiences of regulatory forbearance working with success, primarily the handling of the exposure of the U.S. money-center banks to Latin America in the second part of the 1970s and the first years of the 1980s, one may generally see it as unsatisfactory that legal rules are left unenforced. During the recent crisis, policymakers have been careful to avoid the suspicion that they have tried to practice regulatory forbearance. The stress tests performed by the U.S. authorities on 19 important financial institutions in Spring 2009 can be seen as a method through which the authorities tried to dispel suspicions that they might be pursuing a policy of regulatory forbearance. The U.S. stress tests are generally seen as a success, leading to a boost of confidence in the financial markets. In 2010, stress tests have also been performed on European banks. The recent financial crisis has further demonstrated a number of problems associated with practising solution (iii), i.e., the raising of capital through the financial

12 168 Clas Wihlborg, Finn Ostrup & Lars Oxelheim markets. From August 9 th 2007, inter-bank funds started to dry up due to the expectation of losses in financial institutions caused by exposure to the U.S. real estate market. In order to secure continued access to capital for financial companies, governments have had to intervene by guaranteeing claims on financial institutions. Difficulties with respect to raising equity capital have also been experienced during previous crises. Thus, during the Swedish banking crisis in , the largest Swedish bank, SE Banken, found it impossible to raise new equity. This was also the case during the Norwegian crisis in 1991 when the large Norwegian commercial companies, in spite of heavy government pressure, kept back from providing new finance to the crisis-ridden Norwegian banks. Solution (iv), i.e., the merger between a distressed institution and a sound financial institution, has become more difficult as financial institutions have grown in size. It is more difficult to find a candidate for taking over a large financial institution than a small one. In general it appears unsatisfactory if financial structure is to be determined by wrong lending decisions in financial institutions rather than by long-term considerations such as advantages of scope and scale which show up in the underlying earnings potential of financial institutions. A further important objection against mergers as a procedure for handling financial crises is the desire to maintain competition. Over the recent decades, concentration has grown in national financial sectors and it can be seen as undesirable if competition is further reduced due to financial crises. The merger between Lloyds TSB and HBOS in Britain was only made possible through a relaxation of competition rules. It has further diminished the possibility of using mergers as a way to solve problems in financial institutions that shareholders have become more active in trying to secure better deals. Recent examples include the successful attempts which were made by the shareholders in Bear Stearns and in Wachovia to raise the share price which were originally agreed in the take-over. In the case of Wachovia, the take-over deal suggested by Citigroup was reversed and the bank went to Wells Fargo. One may also point to the trouble surrounding the take-over of Fortis by BNP Paribas in Belgium and the German government s problems with the minority shareholders in Hypo Real Estate. Finally, solution (v), i.e., the injection of public funds in distressed financial institutions, possibly in the form of the government taking over the financial institution in question, has been the preferred solution in the case of many collapses of financial institutions. As a matter of fact, with the government taking over some of the most important banks in the United States, Britain and other countries (Netherlands, Germany, Ireland), public ownership has been practised on a larger scale as a crisis resolution mechanism during the recent crisis than before. Previous examples of countries using this solution include France (Crédit Lyonnais), Japan, Norway and Sweden and also to some extent in Spain (the collapse in the Rumasa Group in 1983). It speaks in favour of the solution that it is easy to practice.

13 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 169 The injection of public funds is tempting seen from a political perspective because problems are solved in the short term while the costs related to the solution show up in the longer term. In the long term, problems will arise especially in three areas: (i) higher interest costs related to the servicing of public debt, (ii) a stronger inclination for risk because moral hazard is not countered, and (iii) there is no reduction in debt, implying that the economy does not move towards a long-term equilibrium. It may also be seen as inappropriate that the government should perform the task of rescuing financial institutions through the use of public funds. The consideration to reduce and, possibly, to remove uncertainty can be seen as a further important reason why recourse to government funding should be avoided. Thus, the use of government finance will open up for an ongoing discussion of the best timing for the government to pull out. It further increases uncertainty that decisions in financial institutions, e.g. regarding lending to specific activities, may come under political pressure. Under the recent crisis there have been demands for a continuation of lending, especially to domestic households and businesses. It is likely that it will be increasingly difficult to solve financial crises through the use of public funds. The rising size of financial institutions means that more public funds will have to be used for the rescue of troubled institutions. This will give rise to stronger criticism from those groups who stand to lose from such rescue operations, i.e. those groups of taxpayers who have no direct stake in the troubled institution. As a further complication, the rise in the international activities of financial institutions means that public funds for the rescue of financial institutions may be used for the benefit of foreign customers. This may give rise to criticism and may turn out to be politically unacceptable. For the member states of the European Union, the use of public funds in troubled financial institutions may increasingly cause problems in relation to the competition rules in the EU Treaties. As European legal and political integration intensifies, it is likely that the European Commission over time will show less flexibility in its interpretation of EU competition rules. 7. AN ALTERNATIVE SOLUTION: THE REDUCTION OF DEBT DURING A CRISIS It has been discussed above that the experience from the financial crisis since 2007 and from other recent financial crises strongly discourages that policy-makers use the winding-up of financial institutions as a crisis resolution mechanism. The windingdown of troubled financial institutions has turned out to be infeasible, not least for political reasons. This raises doubt about the realism of the procedures which are being drawn up in a number of countries and which involve the winding-down of financial institutions. The discussion has also highlighted a number of problems related to the crisis resolution procedures which were mentioned under (ii)-(v) above. Thus, the consideration not to limit competition further and the difficulties related to finding

14 170 Clas Wihlborg, Finn Ostrup & Lars Oxelheim suitable partners seems to rule out mergers as a method to solve crises in financial institutions. Both the experience of the recent crisis and previous crises suggest that it is virtually impossible for distressed financial institutions to raise capital through the capital market, leaving out the option of raising capital through new issues in the stock market. It has also been discussed above, that the rescue through the injection of public funds is efficient in countering difficulties in the short term but may generate a number of future problems. In addition, it will be increasingly difficult to practice. Having considered the problems related to options (i)-(v) for crisis resolution, the discussion leaves us with option (vi), i.e., the restructuring of distressed financial institutions through a reduction of debt. A restructuring through a reduction of debt involves two major advantages. First, the economy is moved towards a new long-term equilibrium characterised by a lower debt level. Second, the reduction of debt makes it possible for the troubled institution quickly to resume lending. Four procedures for the reduction of debt in troubled financial institutions can be perceived: (1) debt is written down, for example through a hair-cut which is implemented quickly, (2) certain classes of debt are converted into equity at the going share price, (3) debt holders are given the option to convert into equity by means of a procedure whereby debt holders are accorded the right to bid for the company according to seniority, and (4) assets in the distressed financial institution are transferred to a subsidiary which can continue the financial activities. Solution (1), i.e., the writing-down of debt, could involve a procedure in which debt is written down after the financial supervisory authority has examined the financial institution and found that all equity is lost. 11 In implementing the procedure, it seems adequate only to reduce certain types of debt. Seen from the perspective of corporate discipline, it would be appropriate that especially those debt holders who have easy access to information about the troubled financial institution and are therefore able to assess its creditworthiness, should be subjected to the risk of having their debt reduced. To reduce the value of deposits may be a bad idea. It would cause a big increase in information costs and raise the risk of bank runs if depositors were prone to credit risk in connection with deposits, especially deposits used for payment transactions. The write-down of debt requires that the equity is lost. Otherwise, shareholders will gain an advantage at the expense of debt holders. This means that it is impossible to use the procedure in the case in which equity is still left in the financial institution while being insufficient to cover solvency requirements. It complicates this solution that it is usually difficult to ascertain to what extent the equity is intact. This is particularly difficult under a financial crisis with a large amount of uncertainty surrounding the valuation of assets. The arbitrary valuation of equity reduces the protection enjoyed by shareholders and may for this reason also give rise to political controversy which may make the solution difficult to handle. Shareholders may exert pressure on policy makers that they are treated unfairly.

15 Crisis Resolution in Financial Institutions: The Experience from Recent Crises 171 The most important objection against the forced write-down of debt arises from the possibility that debt holders may withdraw if there are expectations that the procedure may be practised. Prior to a forced write-down of debt, rumours will abound concerning the financial soundness of the company and, depending on these rumours, debt holders may find it profitable to withdraw. During the recent financial crisis, there were many cases of financial institutions finding themselves shut out from financial markets, e.g., Northern Rock in September 2007 and Bear Stearns in March At least in smaller economies, it further complicates the forced write-down of debt that debt holders may reside abroad. It is perceived as creating a bad reputation in international financial markets if foreign investors lose money from placing in national financial institutions. This may make it more difficult to raise future finance in international markets. The authorities will be subjected to strong pressure not to implement the solution of writing down debt because it will be argued that the solution will bring about a new Lehman Brothers situation with a big jump in risk premia and a sudden stop of finance. The near-panic surrounding the bail-out of Greece in Spring 2010 is an example at hand. For this reason, it may be difficult in the future to practice resolution procedures which involve that creditors will experience losses. Policy makers will also be subjected to pressure not to let creditors experience losses because such losses may be seen as unfair. A second solution is a procedure under which debt is converted into equity at the going share price. The solution may be practised for all or, perhaps more realistically, for certain classes of debt. One may perceive that claims on financial institutions are divided into different classes. For certain of these classes a provision is included in debt contracts that the claim may be converted into equity at the going share price in certain situations. One may, for example, perceive a solution in which debt is divided into three classes: (a) deposits which are fully insured, (b) short-term finance raised from other banks, and (c) other debt, including bank bonds, which carries the obligatory condition that it may be converted into equity in certain situations. One possibility is that the conversion can be required if the company fails to meet solvency requirements. One may also perceive a broader provision which makes it possible to undertake a conversion if the authorities find it necessary to increase solvency. The authorities may, for example, during a financial crisis require that more capital is needed to reduce uncertainty. The conversion of debt into equity has the advantage over the write-down of debt that existing shareholders are not wiped out. Thus, the procedure avoids the problems associated with the evaluation of the company which results when there is a write-down a debt. The existing shareholders are, however, still punished because they will see their equity thinned out by the admission of new equity. This means that moral hazard is countered. It is further an advantage associated with the solution that debt holders will suffer no direct losses as they are left with equity of the same value as their debt. This

16 172 Clas Wihlborg, Finn Ostrup & Lars Oxelheim removes the incentive for debt holders to stop the funding of a financial institution when there is a risk that the institution is unable to meet the solvency requirement. Financial institutions may even find it easier to raise finance because the possibility of conversion reduces the likelihood that the financial institution will be required to file for bankruptcy. The conversion of debt into equity removes the incentive to withdraw funds from a troubled institution. With a conversion of debt to equity, debt holders will find it difficult to exercise pressure on policy makers not to use the solution on the ground that debt holders are unfairly treated. Thus, debt holders will receive something in return for their debt claims, i.e., equities with the same value as their debt. A third solution is that debt holders bid for the company according to seniority. This procedure has been suggested by Lucian Bebchuk. 15 Debt holders are divided into different classes according to seniority. In the case of bankruptcy, the different classes of debt holders are succinctly offered the choice to take over the company in respect of the claims from senior debt holders. A main advantage associated with the proposal is to resolve a crisis situation quickly while existing bankruptcy procedures invite stakeholders to wrangle over the valuation of assets. As a procedure to solve crises in financial institutions, the solution encounters the problem that it is time-consuming. The activities of a financial company have to be discontinued during the time period that it takes to implement the procedure. Furthermore, the procedure is complicated. Finally, a fourth solution involving a reduction in debt consists in the transfer of assets in the troubled financial institution to a newly-established subsidiary which will continue the financial activities of the parent company. To this subsidiary could also be transferred those categories of debt e.g., deposits which are left unimpaired. This procedure has the advantage that financial activities can be continued with sufficient capital in the newly-formed subsidiary. The rights of existing shareholders are respected because the shareholders are left with the ownership on the subsidiary. The parent company can file for bankruptcy if the equity in the parent company has been eroded to such an extent that the equity is lost. The parent company can, however, also continue normally in the case where equity has fallen below solvency requirements while being still positive. Choosing between the four solutions set out above, the various problems related to solution (1) seems to rule this out. Solution (3) also encounters various problems, in particular that it is complicated and time-consuming. The best solution seems to be (2), i.e. the conversion of debt into equity at the going share price. Solution (4) is also feasible, involving the transfer of assets and certain liabilities (e.g., deposits) to a subsidiary which will continue financial activities while a parent company is left with the remaining liabilities and with assets in the form of shares in the financial subsidiary. 8. SUMMARY AND CONCLUSION The article has examined different procedures for handling crises in financial institutions. Policy makers have currently come out in favour of allowing financial