David Mayes Chicago 5-6/10 BRIDGE BANKS AND TOO BIG TO FAIL/ SYSTEMIC RISK EXEMPTION David G Mayes University of Auckland

David Mayes Chicago 5-6/10 NOT TOO BIG TO FAIL Need means of keeping key functions operating in the case of failure to avoid unacceptable disruption to the financial system Direct impact problems –Too many depositors to allow gap before they can access their funds –Key player in particular markets – disruption and fall in asset prices –Key part of payment system Contagion – indirect impact –Run on otherwise healthy banks, general loss of confidence

David Mayes Chicago 5-6/10 COUNTRY DIFFERENCES In US Systemic Risk Exemption allows FDIC to take a wider view and not simply minimise its own losses when resolving a failed bank ‘serious adverse effects on economic conditions and financial stability’ –Normally loss minimising by the FDIC is quite a good match with overall loss minimisation – spillovers are small and FDIC equates with the junior creditors –Never used –Occurrence may be greater in small countries where a few banks are dominant

David Mayes Chicago 5-6/10 NEED TO BE ABLE TO ESTABLISH WHAT SYSTEMICALLY IMPORTANT ‘Replaceability’ (Hüpkes) Context dependent – how fragile is rest of system Market share might allow the drawing of prima facie lines Definitions of what does/does not constitute financial stability not very helpful

David Mayes Chicago 5-6/10 ALL AN ISSUE OF EXPECTATIONS ‘financial stability is a state of affairs in which an episode of financial instability is unlikely to occur, so that fear of financial instability is not a material factor in economic decisions taken by households or businesses.’ (Allen and Wood, 2006) Can be related to measurable indicators but likely to be highly nonlinear and only clear when the authorities misjudge it

David Mayes Chicago 5-6/10 ONE OBVIOUS STEP IS TO REDUCE SYSTEMIC RISK Avoid banks getting too big. Avoid too much concentration in individual markets Better risk management Strong PCA to solve problems before failure

David Mayes Chicago 5-6/10 REQUIRMENTS FOR HANDLING THE FAILURE OF A SYSTEMIC BANK A rapid implementation so that the systemically essential functions can be maintained without a material break A predetermined means of deciding what losses are to be taken into account and how they are to be assessed A means of allocating losses that respects the hierarchy of claimants under insolvency and does not make the claimants any worse of than they would be under normal insolvency procedures. the method should not reduce the risk that shareholders and those responsible for the losses would otherwise bear, in particular it should not introduce a moral hazard that would encourage institutions to take on increased risk the method needs to be equitable across financial institutions irrelevant of their size or the sequence in which insolvencies occur.

David Mayes Chicago 5-6/10 NZ APPROACH Outsourcing policy Banks must organise themselves and their relationship with the authorities in such a way that a failure or other major shock can be handled without having significant impact on the system –defined as –The bank’s clearing and settlement obligations due on a day can be met on that day –The bank’s financial risk positions on a day can be identified on that day –The bank’s financial risk positions can be monitored and managed on the day following any failure and on subsequent days –The bank’s existing customers can be given access to payments facilities on the day following any failure and on subsequent days.

David Mayes Chicago 5-6/10 KAUFMAN 4 POINT PROGAMME Prompt legal closure when the bank’s capital declines to some prespecified and well publicised minimum value greater than zero (legal closure rule), Prompt estimates of the recovery value and assignment of any credit losses (haircuts) to de jure uninsured bank claimants, Prompt reopening (e.g., the next business day), particularly of larger banks, with full depositor access to their accounts on their due dates at par value for insured deposits and recovery value for uninsured deposits and full borrower access to their pre-established credit lines, and Prompt re-privatisation and re-capitalisation of the bank in whole or in parts at adequate capital levels.

David Mayes Chicago 5-6/10 METHODS OF KEEPING SYSTEMIC FUNCTIONS OPERATING IN THE FACE OF FAILURE Traditional solution – Open Bank Assistance –Not enough time to work out how to do anything else –Large banks can be so complex it is difficult to sort out what the insured deposits are This is in effect ‘too big to fail’ Purchase and assumption difficult –buyer cannot complete due diligence –Scale can lead to competition problems –Possibly best broken up

David Mayes Chicago 5-6/10 METHODS OF KEEPING SYSTEMIC FUNCTIONS OPERATING IN THE FACE OF FAILURE Traditional solution – Open Bank Assistance Purchase and assumption difficult Bridge banks offer a way forward –Temporary solution till return to private sector –Takes bank away from existing owners –Can to some extent separate out the systemic functions –Need legal power – this not possible in many EU countries –Only used by FDIC10 times and not in last 12 years –Some experience in around 6 other countries

David Mayes Chicago 5-6/10 EXPERIENCE WITH BRIDGE BANKS Available since Competitive Equality Banking Act of 1987 in light of experience from Continental Illinois bridge bank is a new limited life national bank, chartered by the Comptroller of the Currency Used 10 times, only once since FDICIA Enables FDIC to separate banks from the holding company. Sometimes has put them all in one bridge sometimes into separate ones depending on what makes them most saleable/least loss. Buys time, keeps charter value FDIC suggests it is only way to handle a large failure BUT not sufficient on its own – need greater preparation and early access to a large bank to be ready fast enough Is operation under FDIC control going to increase losses

David Mayes Chicago 5-6/10 THE MAYES HALME AND LIUKSILA (2001) SOLUTION Very similar concept to bridge bank Authorities intervene at prescribed benchmarks – preferably above zero but in EU zero net worth – and takeover the bank from the shareholders Make an approximate evaluation of the extent of any shortfall and make it good, probably by writing down the claims in proportion, starting with the most junior (equity for debt swap?) Reopen the bank as usual on the next trading day probably with guarantee against future loss No one worse off than in insolvency Requires public law on banks to operate Adequate access to information and bank systems to make appraisal and identify claimants

David Mayes Chicago 5-6/10 WHO SHOULD BE RESPONSIBLE? Potential conflict of interest for supervisor – bank failure = regulatory failure. Conflict for central bank (Kahn and Santos) because of exposure to loss Need agency that is closely involved with systemic institutions so they are convinced that the can recover properly in the event of failure or other problems – less important for non-systemic banks? Need set up in normal times to address loss minimisation Does not need to be large but needs to be able to call on staff immediately in the case of a problem.

David Mayes Chicago 5-6/10 POWER TO ACT Key problem for many countries is lack of legal framework for early intervention Need to be adequately informed (involved in bank examinations etc?)

David Mayes Chicago 5-6/10 ISSUES Role of courts Is it possible to distinguish insured from other deposits fast enough to avoid systemic difficulty? Is it possible to carve out systemic functions? Are they legally distinct? Can one really offer equal treatment to small and large banks?

David Mayes Chicago 5-6/10 IN MANY CASES PROBLEM IS MULTI-NATIONAL No single authority has the power to act Conflict of interest bank may only be of systemic importance outside the home country Problems of branches in the EU (Winding Up Directive) May be impossible to operate either intervention OR open bank assistance – home country with power may be unwilling or unable to support entire institution (Swiss case) What is fair burden sharing if failure is partly the fault of the lead supervisor? Do not have agreements on PCA/SEIR

David Mayes Chicago 5-6/10 TWO MAIN DIRECTIONS Give one authority the job and assign it adequate powers Adopt national solutions for each systemic location (this is the NZ and US solution) Make subsidiaries largely free-standing then each can be bridged individually Not possible for EU – not clear that existing co- operation would work – how would a bridge bank be formed? Could be done by an EDIC European Deposit Insurance Corporation but no appetite for international institutions at present Only banks in the EU are likely to have systemic functions