How to make banks safe to fail

Banks cannot be made fail-safe but they can be made safe to fail or, in other words, resolvable. This was the key message Thomas F. Huertas, Partner at Ernst & Young LLP London, conveyed at a SAFE Policy Center Lecture on 2 July.

According to Huertas, the only way out of the dilemma banking supervisors have been caught in since the beginning of the financial crisis was to reform banks in a way that their failure cannot disrupt the economy at large or pose costs to the taxpayer.

Why not learn from the resolution procedures in the non-financial industry? Huertas used the example of airline companies to demonstrate that, in general, an insolvency does not need to interfere with customer operations. For this analogy to be transferred to the banking sector, it would be necessary to separate the capital structure of the bank from the customer activities. The objective would be to restructure a bank’s capital while transactions with customers continue.

As a first main challenge, the starting phase of the resolution process needs to be implemented in the short time span of one weekend (closing of markets in North-America on a Friday and opening of markets in Asia on Monday morning). On this resolution weekend, the bail-in must take place. The supervisor would transfer the bank’s capital into loss-absorbency instruments.

As Huertas pointed out, this should be done in accordance with strict seniority: Fist common equity, then non-common equity Tier 1 capital (e.g. preferred stock), then Tier II capital (e.g. subordinated debt), then other investor obligations such as senior debt. The proceeds from resolution would be used to recapitalize the bank and raise the liquidity necessary to assure continuity of business. Accordingly, there would be no default on repos and derivatives.

In exchange for their original assets, investors that were subject to bail-in would receive “proceeds notes” that entitle them to the proceeds the resolution authority may realize from the restructuring process over time. These claims would again be satisfied according to strict seniority.

To implement resolution in such a way, three steps need to be taken, said Huertas. First, the resolution regime must consist of a legal and contractual framework which gives the resolution authority the power to implement bail-in. Second, banks need to change their funding arrangements to accommodate bail-in. Lastly, financial market institutions have to coordinate their own recovery and resolution planning with that of their principal counterparties.

In the questions and answers session following the lecture, it was discussed whether a distinction between different holders of the assets that are to be bailed-in was necessary. After all, worries concerning the load-bearing capacities of investors have always been the reason why bail-in had been circumvented by political forces. Huertas’ answer to this was that if there were concerns with respect to particular holders of bail-inable debt, there should indeed be restrictions regarding the parties that can hold these assets. He did not, however, share the view that insurances and pension funds cannot be subjected to bail-in. Holders of bail-inable assets need to structure their portfolios and the maturity of their assets in such a way as to be able to absorb losses.