1 A Theory of Bank Resolution: Political Economics and Technological Change Robert DeYoung University of Kansas Jack Reidhill* Federal Deposit Insurance Corporation * The views expressed in this paper are those of the authors and do not necessarily reflect positions held by the FDIC.

2 Recent History: Liquidity over Discipline Headline examples of recent financial institution bailouts: –In Germany, the state-owned bank IKB bailed out by a consortium of other state-owned banks. –Northern Rock nursed along with Bank of England borrowings/guarantees before finally being nationalized. –Federal Reserve subsidizes acquisition of Bear Stearns, makes all creditors whole and stockholders retain value. In each case, authorities chose to preserve liquidity in the financial system, rather than imposing losses and disciplining uninsured creditors. This preference for liquidity over discipline is consistent with decades of bank resolution practices around the world – for failed banks of all sizes.

3 Our Paper This year is the 75 th anniversary of the Federal Deposit Insurance Corporation (FDIC). –Retrospectives are being written. –This paper is a byproduct. –Meant for a non-technical policy publication. We develop a simple theoretic framework to illustrate: –the trade-off between preserving liquidity and enhancing market discipline faced by resolution authorities (RAs). –why failed bank resolution policy so often favors preserving liquidity over enhancing discipline. –the potential social costs of such policies. –how politics, technology, and legal institutions can alter the liquidity-discipline trade-offs available to RAs.

4 Our Paper Our framework is simple, but we think it advances the existing literature and the policy debate. –We use a formal framework to express the ideas and policy prescriptions from many other commentators. –To date, these ideas have been discussed in a less formal, incomplete, and ad hoc fashion. –We focus on all these ideas through the lens of liquidity- versus-discipline. Appendix: We show that the framework is reasonably consistent with 75 years of U.S. bank resolution history. This is a first step: We encourage theorists to formalize, extend, and augment our liquidity-versus-discipline approach.

5 Theories on why bank bail-outs occur Kane (1995): Relationships between the deposit insurer, taxpayer, and depositor comprise an incomplete market, creating incentives for regulators to practice forbearance. Kane & Klingebiel (2004): Regulators bail out uninsured creditors to avoid blame for the failure. Bernanke (1983), Calomiris and Mason (2003), Ashcraft (2005), Ramírez (2007): Bank failures interrupt the lending channel and destroy valuable credit relationships. Large bank failures can cause systemic events. The RA identifies with depositor protection (especially if RA is also deposit insurer). Existing legal institutions (e.g., bankruptcy codes) make it impossible to provide liquidity without a bailout.

6 New resolution practices can reduce the cost of preserving liquidity Kaufman and Seelig (2002) & Kaufman (2003) propose rapid payment of insured depositors and quick access for a portion of uninsured funds via “advance dividends.” –Similar proposals advocated by Kaufman (2004) Mayes (2004), Kaufman and Eisenbieis (2005), and Harrison, Anderson and Twaddle (2007). Bridge banks (increasingly used by FDIC) maintain liquidity for both depositors and borrowers without bailing out owners. These and other innovations aim to reduce economic disruptions when the RA imposes losses on uninsured creditors and owners. That is, improving the tradeoff between preserving liquidity and enhancing discipline.

7 A Theory of Bank Resolution A resolution authority (RA) faces an exogenous bank insolvency, and must decide how to resolve it. The RA chooses a resolution method (RM) that maximizes its own utility. –The RM preserves some non-negative amount of liquidity for depositors and borrowers. –The RM imposes some non-negative amount of discipline on uninsured creditors and owners. –This need not maximize social welfare – that is, we allow for agency behavior. The RA is constrained in its choices: –Technological constraints. –Political constraints.

8 A Theory of Bank Resolution We characterize the preferences of the resolution authority (RA) as follows: –The RA has a strong preference for maintaining liquidity in the financial system. –The RA has only a weak preference for imposing discipline on uninsured depositors, borrowers, and shareholders. –The RA will choose to impose discipline if resolution technologies and legal frameworks permit it to do so without significantly reducing liquidity.

9 A Theory of Bank Resolution The RA solves the following constrained maximization problem by choosing a resolution methodology RM: U is increasing (strongly) in liquidity LQ and increasing (weakly) in market discipline MD. T defines the efficient set of resolution methods RM. G restricts the RM to which the authority has access. maximize U(LQ, MD) subject to: RM ≤ T(technology, legal framework, bank size) RM ≤ G(political and economic conditions)

10 OBA (Open Bank Assistance): RA provides cash, owners keep control. DP (Depositor Payout): RA takes over, pays insured depositors quickly. AL (Asset Liquidation): RA takes over, pays depositors from asset sales.

11 OBA (Open Bank Assistance): RA provides cash, owners keep control. DP (Depositor Payout): RA takes over, pays insured depositors quickly. AL (Asset Liquidation): RA takes over, pays depositors from asset sales. Some institutional details before continuing: Insurance determination: Before paying depositors, the RA must first determine which deposits are insured, and which deposits are not insured. Asset valuations: The amount that the RA pays out to uninsured depositors—say, with an “advance dividend”—may depend on the value of the bank’s assets.

12 Overall improvement in resolution technology (T → T’). Examples: Faster insurance determinations; faster and more accurate valuations of bank assets. The RA can deliver more liquidity and more discipline.

13 New resolution technology: BB (Temporary “bridge bank” run by RA). Depositors and borrowers have full access to funds. Owners are out. RA prefers BB over OBA: More discipline without less liquidity. RA prefers BB over DP: A lower “discipline price of liquidity.”

14 Large banks: Insurance determination, asset valuation more difficult. “Liquidity price of discipline” has increased. For example: Insured depositors mistakenly denied immediate access to funds. Advance dividends small due to uncertain asset valuations. Bank defaults on counterparties, disrupting financial markets.

15 Large bank resolution: Insurance determination, asset valuation, counterparty sorting, are all more difficult. “Liquidity price of discipline” has increased. For example: Insured depositors mistakenly denied immediate access to funds. Advance dividends small due to uncertain asset valuations. What if the RA lacks authority to takeover and/or resolve failed banks? The bank files for bankruptcy, which protects it from its creditors (that is, its depositors). Large amounts of illiquidity. “Liquidity price of discipline” has increased. RA chooses OBA. T bankruptcy

16 Our modeling is…weak. There are plentiful opportunities to improve what we have started: Give the model some structure. –Functional forms for the utility function and the constraints –More formal equilibrium and comparative statics Do only the RA’s preferences matter? –Banks, depositors, and legislatures all maximize, too. A multi-period framework would probably be useful. –We hint at this analysis in the paper.

17 Potential spillover benefits from imposing discipline today: Future moral hazard incentives are reduced for depositors and banks. Can the RA establish a credible threat? If so, the rotation of T shown here will be partially or fully reversed.

18 OBA is an expensive policy. Legislature reacts with a “least cost resolution” law that limits the RA’s ability to preserve liquidity. RA utility is lower at LC…but social welfare may be higher. Mere threat of legislation could cause RA to trade liquidity for discipline.

19 Conclusion We argue that the tradeoff between preserving liquidity and encouraging discipline in deposit markets is the central defining feature of bank resolution policy. We offer a first step toward modeling the implications of the liquidity-discipline tradeoff. The model stresses the underlying drivers of resolution authority behavior: –TBTF financial institutions. –Recent episodes (e.g., Bear Stearns, Northern Rock). –Legal frameworks necessary for RA to impose discipline do not exist in all countries.

20 A Theory of Bank Resolution: Political Economics and Technological Change Robert DeYoung University of Kansas Jack Reidhill* Federal Deposit Insurance Corporation * The views expressed in this paper are those of the authors and do not necessarily reflect positions held by the FDIC.