Deposit Insurance Reform and the Need for a Special Bank Insolvency Regime George G. Kaufman (Loyola University Chicago) London School of Economics January 30, 2008 1-22-2008

Why Need Reform? Current system of preventing bank failures and resolving them is frequently inefficient, uncertain, and excessively costly

Basic Purpose of Current Deposit Insurance Systems Stop bank runs by insured parties by eliminating threat of credit losses (if credible) Limit bank fire-sale losses from runs and threat of “technical” insolvency Limit contagion

Problems with Current Deposit Insurance Two potential losses in bank failures Credit losses (PV-RV; K < 0) Liquidity Losses (limited access / freezing due to delayed sales) Shifts not eliminates depositor credit losses Does not address customer liquidity losses Encourages bank moral hazard risk-taking Greater portfolio risk Lower capital Encourages regulatory forbearance Funding not withdrawn, bank can stay open Thus, increases probability and cost of bank insolvencies in long run

Solution to Deposit Insurance Problem Eliminate not shift credit losses Eliminate not neglect liquidity losses Focus on prompt legal closure at low but positive capital (no credit loss) and prompt customer access to accounts (no liquidity loss) Make deposit insurance redundant (but not unnecessary) Need special bank bankruptcy regime in most countries

Four-Point Efficient Bank Insolvency Resolution Program (Eisenbeis-Kaufman) PCA to prevent insolvencies, but with prompt legal closure at K > 0 (minimize credit losses) Prompt estimation and allocation of credit losses to uninsured claimants (enhance market discipline) Prompt sale/bridging of insolvent bank (minimize liquidity losses) Pay insured depositors par Pay uninsured depositors advance dividends of estimated recovery amounts Provide performing loan customers access to credit lines 4. Prompt reprivatization at above minimum capital

Four-Step Program Requires Fund or borrowing authority by insurer to make payments to depositors before final sale Credible PCA framework to minimize bank insolvencies and buy time for appropriate regulatory actions Prompt and efficient bank bankruptcy regime

Keep Deposit Insurance on Retail Deposits Redundancy / back up Get small depositors off the street and at home / political

Prompt and Efficient Bank Bankruptcy Regime Banks “special” / different Even brief interruption of many activities, e.g. deposit and credit access, payments clearing / settlement, can have major adverse externality Avoiding adverse externalities trumps resurrecting bank as firm Prompt legal closure (minimize credit loss) and continuity of service with certainty (minimize liquidity loss) prime import Corporate bankruptcy regime generally cannot provide above results – not prompt, not efficient, not certain

Case for Bank Regime: U.S. Bank and Corporate Bankruptcy Codes Issue Bank (FDIA) Corporate (Chapter 11) Reason for Difference Objective Minimize loss to FDIC Resurrection of large firm; maximize long-term firm value Public interest in FDIC as creditor Importance of bank services vs. bank as firm Exception Systemic Risk None Adverse externality Pre-failure PCA Voluntary Adverse externality and deposit insurance Trigger event Regulatory insolvency Major default or anticipation Quicker, minimize credit loss

Case for Bank Regime: U.S. Bank and Corporate Bankruptcy Codes Issue Bank (FDIA) Corporate (Chapter 11) Reason for Difference Initiator Regulator Major creditor Deposit insurance, quicker Process Administrative Judicial Quicker, greater certainty Receiver FDIC Appt by court Expert/regulator Stay No (with exceptions) Yes Uninterrupted service

Case for Bank Regime: U.S. Bank and Corporate Bankruptcy Codes Issue Bank (FDIA) Corporate (Chapter 11) Reason for Difference Legal certainty and priorities Strong Weak, negotiation Uninterrupted service, advance payments Shareholder interests Terminated except for residual value Weak but subject to negotiation Speed up process, certainty Review / Appeal Weak, ex-post Ex-ante Speed up process, certainty Expense Low High Efficiency

Why Review Past Problems and Make Case for Reform? Optimist – Avoid repeating errors George Santayana (1863-1952) “Those who cannot remember the past are condemned to repeat it” Pessimist – Most do remember the past George Kaufman (alive) “Those who can remember the past will agonize first and then repeat it”

Thank you