Changing Bank Resolution Regimes – the U.S. Case

Changing Bank Resolution Regimes – the U.S. Case

Magdalena Ignatowski*
Josef Korte**
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confronted with seriously distressed banks during the global financial crisis and the
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insufficiencies of applying corporate bankruptcy mechanisms to bank insolvencies
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constituted a default action in derivative contracts, leading to massive terminations
of derivative positions. As Lehman Brothers was not allowed to provide liquidity
to its subsidiaries, its foreign legal entities entered bankruptcy proceedings as
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had been materially different from Lehman Brothers’, its banking business
continued to operate without major interruptions, unlike the failure of Lehman
Brothers. Since then bank regulators and legislators have realized the importance
of effective and appropriate bank resolution mechanisms and brought into force
significant changes to resolution regimes in an effort to prevent future crises. Have
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implications of such changes on bank behavior?
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resolution mechanisms to induce incentives for prudent bank behavior and apply
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the theoretical foundations regarding bank resolution and its implications for bank
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Resolution of distressed banks is probably the most intricate regulatory area
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to preserve it as a going concern and resolving the bank either through acquisition
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bailed out increases banks’ moral hazard as creditors anticipate loss protection
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evidence tends to support the view that bailout guarantees an increase in
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guarantees cease to be implicit through a credible and enforceable improvement
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Problems and Opinions
in bank resolution regimes, banks should change their behavior towards more
prudent behavior and lower probability of distress. A comprehensive theoretical
model of how improvements in resolution regimes interact with bank behavior
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model assumes banks that are inherently fragile and suffer from moral hazard
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help to establish discipline, available resolution technologies usually suffer from
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resolution technology available to the regulator is the second parameter determining
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technology, such as legal changes or operational empowerment of the regulator,
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likely. If the technological improvement is known and credible to banks, they will
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an improvement in resolution technology should induce more prudent behavior,
ceteris paribus. Second, this outcome depends on the credibility of the application
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Several empirical studies confirm the tendency for bailout and forbearance in times of macro
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find that regulators are less likely to close a bank if the whole banking system is in a crisis.
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and thus credible when complemented by political will, i.e. a low time discount
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and liquidate any financial institution in distress through its administrative
resolution regime.
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represents a significant technological improvement on these two issues. As a first
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particularly commercial banks, thrifts, and savings banks holding a national or
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resolution regime stems from the conviction that banks are somewhat distinctive,
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potential for moral hazard due to deposit insurance schemes or implicit guarantees.
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regime takes the special role and functioning of financial institutions into account.
It is designed to allow timely intervention and resolution of insolvent banks while
limiting moral hazard as well as potentially detrimental effects to liquidity, sound
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from the regular, judicial insolvency procedure with regard to insolvency triggers
and initiation conditions, resolution instruments, financing, and possibilities
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powers to promptly intervene upon certain initiating conditions, such as critical
undercapitalization, without having to wait for the filing of a default event or for
court decision. In this case, the license of the bank can be revoked by its primary
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management and shareholders, taking over the bank, and ultimately preparing it
for purchase and assumption by another financial institution or for closure and
liquidation. In order to preserve liquidity, charter value, and operations of the
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it comes to the failure of bank holding companies, financial holding companies,
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typically protect the owners from creditors, take long time periods for resolution,
during which funds for depositors and borrowers might not be available, and
require a restructuring plan as a precondition before making decisions on larger
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insolvency procedures might cause severe disruptions. :KLOH WKHVH LQVWLWXWLRQV
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corporate law was apparently inappropriate to efficiently resolve their insolvency.
Hence, this was widely considered as a major deficiency in the resolution regime for
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these institutions from actual failure by making bailout the only available choice
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financial crisis, the deposits of Bank of America alone were about 10 times larger
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illustrates the second significant issue gripping the resolution technology available
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insufficient financial endowment of the regulator prevented an effective application
of bank resolution and made bailout the regulator’s preferred choice in most cases
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insolvency and resolution regime to financial institutions previously uncovered
by bank resolution law. More specifically, it stipulates that any firm determined
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liquidate the firm, to pursue a purchase and assumption resolution, or to set up
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replace the management, and protect liquidity in a way that is superior to regular
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be fulfilled. Firstly, the firm in question needs to be a financial company, i.e. a bank holding
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dominantly engaged in financial activities. Secondly, it is not an insured depository institution
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otherwise applicable legal provisions would have adverse consequences for financial stability,
there is no viable private sector alternative, the impact on creditors and shareholders is appro
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In fact, the board of the determined covered financial company can ask the Secretary of the
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Problems and Opinions
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So far empirical evidence on resolution policies has been mostly limited to the
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empirically investigates the impact of changes or improvements in resolution regimes
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their recent paper, the authors empirically test the effects of the introduction of the
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change for different types of banks and show that banks that are more affected
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incentives for prudent behavior. However, the authors also show that this effect
does not hold for the largest and most systemically important banks, concluding
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company that would be available for repayment of the funds.
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Bezpieczny Bank
2(55)/2014
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group of financial institutions into a special bank resolution procedure. Rather than
focusing only on insured depository institutions, the special resolution regime is
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banks that are most affected by these changes.
Based on our analysis and the previous literature, we emphasize two
fundamental features of effective bank resolution regimes that, in our view, can
set incentives for prudent behavior and thus help to prevent future financial crises.
First, a bank resolution regime that takes into account the special role of financial
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and that commands sufficient legal and financial resources is essential to creating
a credible resolution threat for financial institutions. Second, comprehensive
coverage of financial institutions in general will avoid incentives to shift risks
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elements can be an effective and credible threat that disciplines banks towards
more prudent behavior.
Abstract
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confronted with seriously distressed banks during the global financial crisis and the
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realized the importance of effective and appropriate bank resolution mechanisms
and have brought into force significant changes to resolution regimes in an effort
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requirements for resolution mechanisms to induce incentives for prudent bank
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Key words:EDQNUHVROXWLRQ2UGHUO\/LTXLGDWLRQ$XWKRULW\
98
Problems and Opinions
References
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0DLODWK*-DQG0HVWHU/-Ĵ$SRVLWLYHDQDO\VLVRIEDQNFORVXUHĵJournal of
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99