Tag: bank resolution

Looking Back on Occupy Wall Street

The evening of September 16, 2008, I met Randy Kroszner for dinner at Et Voila in the Palisades just outside of Georgetown. He arrived late explaining that the Fed’s monthly monetary policy meeting had lasted longer than expected. Randy is a Governor on the Board of Governors of the Federal Reserve. The attempt to rescue Lehman Brothers over the weekend had failed and it had declared bankruptcy the day before, so we had a lot of interesting things to talk about. Randy didn’t mention that the Fed had just agreed to lend up to $85 billion to AIG to cover its expected loses on its mortgage related Credit Default Swaps, thus giving the U.S. government a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. When news of the AIG bailout was posted on my phone around 9:00pm during our meal, I asked Randy what in the world was going on. He was reluctant to discuss the topic uncertain whether the source of my news was a leak or an official Fed press release.

The housing bubble had started to deflate in 2007 and homeowners and their mortgage financiers were coming to grips with the reality of significant financial losses. “The DEFs of the Financial Markets Crisis” and “The Big Bailout–What Next?” While the Federal Reserve quickly reacted to inject liquidity into the banking system to compensate for the freezing up of the interbank credit market that followed the Lehman Brothers-AIG shockwaves, the key questions were who would bear these losses and how should they be contained to avoid spilling over to the financial system more broadly.

The Fed, with the help of $700 billion authorized by Congress in the Troubled Asset Relieve Program (TARP), bailed out Wall Street and contained the spread of potential bank failures. It was a scary time for all involved. Looking back from the relative calm of today with criticism of policy actions taken then is a bit unfair but how else are we to learn from experience?

The government actions in 2008 can be broadly stated as: a) providing all of the liquidity the financial sector needed following the Lehman Brothers collapse and financial panic; b) bailing out large banks and other financial institutions that might have been insolvent whether they were or not; and c) leaving underwater homeowners to drown. The first of these—providing liquidity—is universally accepted as a proper function of a central bank and one that the Fed executed well. The other two—bailing out banks but not homeowners—are the subjects of this note. I will review them from both an economic and a political perspective.

The economic rational for bailing out Wall Street was that there was a risk, with very uncertain probability, of the failure of large Wall Street institutions spilling over to and bankrupting other financial institutions holding assets in the failed Wall Street firms. Many of them were foreign (especially German Landesbanks) and no one knew for sure where the contagion might end. By saving Wall Street, the argument went, the government was saving Main Street as well (trickle down). Sheila Bair, then the Chairman of the Federal Deposit Insurance Corporation, among others urged the government to bail out homeowners who were defaulting on their mortgages as well. While different policies of homeowner relief were considered the one finally adopted, Home Affordable Refinance Program—HARP, was modest and left Ms. Bair quite unhappy: “Shortly after Fannie Mae and Freddie Mac announced their new plan, Ms. Bair declared that it was inadequate and pointedly said that the government had spent hundreds of billions of dollars to bail out financial institutions like American International Group, the giant insurer.” “White House scales back a Mortgage relief plan”

From economists’ perspective, bailing out anyone creates a moral hazard. If market players profit from risky bets when successful but expect that the government will pick up the tab when they are unsuccessful, they will take greater (excessive) risks. No one was eager to bail out property flippers (those who bought property with the intention of reselling it at a higher price rather than move in) from their failed gamble. But the same logic applies to those financial firms that lent the mortgage money in the first place or that kept the financing cheap by providing it from the derivatives market of Mortgage Backed Securities, etc. Government policy makers attempted to design their bailouts to minimize the moral hazard they were creating, especially after the foolish and panic driven bailout of Bear Stearns in March 2008. But policy was driven by government’s fear of financial contagion.

The political optics of bailing out mortgage lenders but not homeowners is not good. Why did politicians choose to support one but not the other? Moral hazard is a problem with both. The reality is that Washington politicians were (are) much closer to Wall Street than to Main Street and are thus more sensitive to Wall Street’s concerns. Growing recognition of this fact adds some understanding to the hostile attitudes toward Washington expressed by Trump supporters.

By far the better policy would have been, and in the future is, to stick by the existing rules for bearing losses (our bankruptcy and default laws), i.e. no government bailouts. Our bankruptcy laws and procedures are actually quite good. “Resolving Failed Banks” For starters Bear Stearns shareholders should have lost everything. On the underwater homeowner side, mortgage lenders have always sought to minimize their losses when borrowers are unable to repay according to the original terms of a loan. Often the least cost resolution is for the lender to agree to easier terms and to restructure the loan. Evicting the “owner” and selling the property, especially when it is under water (i.e. valued at less than the mortgage amount), is a costly undertaking and writing down and restructuring the loan is often the least cost approach. However, government driven programs can rarely match the lenders’ ability to restructure loans one by one that can be honored by the homeowner while minimizing the loss to the lender. “Changing direction on bank regulation”

Our government has increasingly attempted to micromanage the private sector, especially the financial sector. This is a mistake. It should establish clear and pragmatic rules for conducting business and for resolving failures (workable bankruptcy laws). “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” Within this broad legal framework, which to a large extent already exists, individual firms would be held accountable for the conduct of their business by their customers and their owners. If they fail, the first losses must fall on the owners (shareholders), who have a greater incentive to do well and have better market information on which to act than do government regulators. This requires a change in attitude and direction of government’s role in our lives.

Cyprus: Bailing in and capital controls

Three European countries with oversized banking sectors have suffered major bank failures. Two of them are in the Euro Zone (Ireland and Cyprus) and one has its own currency (Iceland). Iceland and Cyprus imposed temporary capital controls, while Ireland did not. Iceland imposed losses on the foreign depositors in its large, failed banks while Ireland, under EU pressure bailed out everyone (even bond holders) except the shareholders.

The jargon used to describe much of this—“bail outs,” “bail ins,” “haircuts,” “good bank bad bank splits,” etc.—can be confusing. In this note I attempt to clarify the key concepts and their importance via the examples of Iceland, Ireland and Cyprus.

Market discipline vs. supervision and regulation

Incentives always matter. Banks, like any other business, are in business to make money. But the amount of risk they take (more risk more return—ON AVERAGE) depends on who regulates their behavior. Fundamentally, the market can regulate bank risk taking—by the willingness of investors to lend to banks and of depositors to place their money there—or the government can.

The last century has seen a steady shift away from market regulation toward government regulation. Deposit insurance is an important factor contributing to that shift by removing any concern by smaller depositors of the condition of their bank. Thus deposit insurance requires a substitution of the due diligence that used to be performed by small depositors with increased government regulation of bank risk taking. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides much of that supervision and regulation.

However, increasingly countries became unwilling to allow banks to fail. While shareholders might be wiped out when a bank became insolvent (i.e., when the value of its assets fell below that of its deposits and other liabilities), country after country have “bailed out” all other bank creditors, including uninsured depositors. Bailing out depositors and other creditors means giving taxpayers’ money to the bank to make up for its losses and thus cover its liabilities (other than shareholders).  For large, “systemically important” banks (meaning banks whose failure could cause fatal losses in other banks or firms), most countries are not willing to let them fail at all, thus bailing out shareholders as well in order to allow the banks to continue to operate. Hence the problem of banks that are “too big to fail.” Bailing out uninsured depositors made deposit insurance redundant and pointless. Market discipline was pushed aside all together. The safety and soundness of banks came to rest almost completely on the adequacy of regulations and the skills of supervisors. Bank owners, the only ones who care any more, now have a financial incentive to take big risks for potential big gains. If they lose, as they do from time to time, the government, i.e., tax payer, will pick up the bill.

It is desirable to shift more of the discipline of bank risk taking back to the market by convincingly putting bondholders and large, uninsured depositors at risk of loss if their bank becomes insolvent. They have a financial incentive to get it right that supervisors do not.

Resolution of insolvent banks

Best practice when a bank becomes insolvent is to resolve it quickly and fully and to put a large part of the cost of its losses on uninsured creditors (shareholders, bond holders and uninsured depositors in that order).  Normal company bankruptcy can take the form of shutting down, locking the doors, and selling off anything of value (normally taking a few years) and distributing the proceeds to the creditors in the order of the legal priority of their claims. It is a transparent and objective, but slow process. In many instances the highest value for a failing company is obtained by selling it whole or in part to another company that is able to run it more efficiently. The recent bankruptcy of Sara Lee and sale of its best products to other companies is an example.

The bankruptcy and resolution of an insolvent bank is more challenging because of the ease with which depositors can run when they sense trouble. Thus the weekend sale of such banks in whole or in part to another bank is the norm for small or medium-sized banks in the U.S.  The good bank bad bank split, as occurred recently in Cyprus, is a recent example. Laiki became the bad bank that was closed and is being liquidated and the Bank of Cyprus became the good bank. After wiping out its shareholders and bondholders and administering a large haircut to the uninsured depositors, it acquired the insured deposits of Laiki and an equivalent value of good Laiki assets. Such bank resolutions, which freeze depositors’ funds only for very short periods (a few days), require special bankruptcy laws for tailored for banks. As the surviving good bank must continue to operate with little to no interruption, more judgment and uncertainty is involved in valuing the assets that it acquires from the bad bank.

It is instructive to look more closely at the resolution process used in Cyprus. First, the two major banks in Cyprus, Laiki and Bank of Cyprus, incurred large losses on their holdings of Greek sovereign debt when all banks were required to “voluntarily” write off about 75% of its value. The magnitude of this loss was clear and well-known from October 2011. The only issue was who would pay for it, the Cypriot government, the EU, or the creditors (depositors) of these banks. Depositor’s obviously thought that they would be bailed out (i.e. that the Cypriot government or the EU would pay for the losses of Laiki and Bank of Cyprus) as had been all depositors in Europe before them, though the deposit liabilities of the Bank of Cyprus fell from 37.1 billion Euros at the end of 2010 to 32.1 billion at the end of 2011 to 28 billion at the end of September 2012 (the latest available).

After a terrible false start in which the Cyprus government attempted to pay for the losses by levying a wealth tax on all depositors (of good and bad banks), Cyprus choose to impose the entire loss on the respective banks’ owners and creditors, and to undertake the good bank bad bank split briefly described above (see my earlier blog on the subject: https://wcoats.wordpress.com/2013/03/27/the-cyprus-game-changer/). This was a dramatic change in approach that shifted the risk of bank behavior back to uninsured depositors. Many were shocked.

This approach is relatively easy for known losses and should have been undertaken a year and a half earlier when the Greek debt write off occurred. But many of the losses a bank has or is incurring are less clear. Of the currently delinquent mortgage loans, for example, how many will actually default and what will be the market value of the mortgage collateral. The recapitalization of insolvent Irish banks suffered from underestimation of the ultimate losses resulting in three separate injections of state money to recapitalize them, which weakened market confidence in the process. In part to deal with this uncertainty but to restore market confidence in the solvency of the surviving good bank (Bank of Cyprus), known losses were totally written off while the additional but uncertain further losses were covered by replacing an equivalent amount of deposits with equity claims on the BOC (shares). If losses turn out to be smaller than was provided for, these claims will have value and will thus reduce the size of the initial haircuts to deposits.

So “bailing out” a bank refers to covering its losses with someone else’s money (tax payers somewhere) and “bailing in” a bank’s creditors refers to covering its losses (after its capital is used up) with bondholders and uninsured depositors’ money via “haircuts” (writing off part of their value). The former “socializes” losses while leaving any gains from successful bets to the private owners and creates a serious moral hazard leading to excessive risk taking by banks. The latter makes depositors financially responsible for excessive bank losses and restores the market’s discipline of bank risk taking. This is very desirable as market discipline is more effective than regulatory discipline, but the dramatic change in the implicit rules in Cyprus was very large and abrupt.

Capital controls

As part of their respective bank resolutions, both Iceland and Cyprus imposed temporary capital controls, which, however, served very different purposes. Iceland has its own currency while Cyprus is part of the Euro zone.

At the time of Iceland’s banking crisis in 2008 its three largest banks had assets 11 times the total annual output of the economy. About half of their assets (largely loans) and their funding were outside of Iceland. Landsbanki, for example, funding its lending with roughly the same amount of borrowing and deposits (a highly risky strategy). When the borrowed funding of these three banks dried up, their size made it impossible for the Icelandic Central Bank (ICB) to provide their needed liquidity (much of which was in the Euro, a foreign currency), resulting in the failure of all three banks in the second week of October 2008.

Iceland honored all insured deposits domestically and abroad but moved all domestic deposits into newly established “good” banks from the three now bad banks, while leaving their overseas, uninsured deposits in these three banks in receivership. To the extent that these banks failed because of illiquidity (the cut off of their borrowed funding), the receivership should be able to recover all losses to depositors from the liquidation of the banks’ remaining assets.

The UK and Netherland’s objected to the unequal treatment of the uninsured deposits of Icelanders and of foreigners. While Iceland’s decision to bail out all of its domestic depositors may be questioned because of the moral hazard it perpetuated, they had no legal obligation to do the same for Euro deposits by foreigners. The UK and the Netherlands stepped in and followed the same policy adopted by Iceland by guaranteeing the deposits of their citizens. They then tried to collect the cost of these guarantees from Iceland, a very questionable claim.

As the three new “good” banks were fully capitalized, they should have been able to withstand any level of deposit withdrawal as long as the ICB was able to provide any liquidity needed against the good but illiquid assets of these banks. The return of depositor confidence to the banks invariably takes time and some depositors wanted to withdraw their funds. However, because Iceland has its own currency, nervous Icelandic depositors wanting to move their bank deposits abroad, would need first to convert them into Euros or U.S. dollars, which would have depreciated the international value (exchange rate) of the Icelandic króna, and depleted ICB’s international reserves. A depreciation of the króna would raise the cost of imports and reduce the standard of living in Iceland. To protect the exchange rate from excessive devaluation, the ICB imposed temporary limits on the amount of money its residents could move out of the country. These capital controls are still in effect.

Lucky Cyprus is in the Euro zone.  After recapitalizing its banks, in part by writing down their deposit liabilities, they should have sufficient assets to cover all of their deposit liabilities and thus to cover any deposit withdrawals. The only issue would be whether the BOC’s assets were sufficiently liquid to cover the withdrawals. Within the Euro zone payments outside the country are made via the Target Payment System. A transfer of deposits from the BOC in Cyprus to a bank in any other Euro zone country is made by debiting the BOC’s clearing balance with the Central Bank of Cyprus (CBC) and crediting the recipient bank’s clearing account with its central bank via Target. If the BOC does not have sufficient funds in its clearing account with the CBC and is unable to sell sufficient assets to increase that balance, it can borrow the funds from the CBC using its good but illiquid assets as collateral. The CBC is able to do the same by borrowing from the European Central Bank (ECB), which is prepared to lend unlimited amounts against good collateral now that Cyprus has undertaken the measures required for the troika’s financial support (i.e., from the EU/ECB/IMF). There is no exchange rate issue or concern. It is purely a matter of the solvency and liquidity of Cypriot banks.

However, establishing sufficient liquidity to fund large deposit withdrawals may take a few weeks or months and thus Cyprus has imposed temporary capital controls that limit the amount of money that may be withdrawn each day as cash or by transfer. If the arrangements enjoy sufficient public confidence in the soundness and viability of the surviving Bank of Cyprus, the deposit withdrawals should be modest. The period of limits on withdrawals should be measured in weeks rather than months or years.

Conclusion

The resolution of Cyprus’s insolvent banks ultimately, after a false start, was achieved by bailing in its creditors. The resolution was relatively quick and seems complete. While Cyprus’s economy is likely to suffer its abrupt adjustment for some time, its banks should now be sound. The dramatic shift of the responsibility of regulating the risk taking of banks to their uninsured depositors, should, if it is maintained throughout Europe despite nervous claims that it is one-off and not a model, restrain excessive risk taking by banks and lead over time to a stronger banking system. In the interim, there may be some disruptive deposit shifts as previously reckless banks are forced by the market to clean up their acts.