Four ways to make it easier to wind up failing banks

2 min

87 shares, 148 points

“A globally active, systemically important bank cannot simply be wound up according to the ‘too big to fail’ plan,” Switzerland’s finance minister said last weekend. “Legally this would be possible. In practice, however, the economic damage would be considerable.”

Fresh from crafting the rescue-by-takeover of Credit Suisse, Karin Keller-Sutter identified a clear problem. Bank resolution, the supposed gold standard of emergency regulatory action, cast in the heat of the great financial crisis of 2007-08, may be mainly decorative.

The bank resolution mechanism clearly needs overhauling before the next round of financial turmoil.

The digitised speed of the run on Silicon Valley Bank exposed deep problems with other emergency measures, such as deposit insurance and central bank funding. Days later, Keller-Sutter and colleagues were able to push Credit Suisse into the arms of UBS. In the process, though, they wiped out the contingent convertible bonds that were supposed to rank above equity in the established hierarchy of liabilities. The “coco”, an important new tool in the post-2008 regulatory box, was shown to be unfit for purpose — or at least prone to the regulator’s whim.

Four main adjustments would make orderly resolution of an imminently failing bank easier to achieve.

As US president Joe Biden suggested this week, regulators need firstly to factor the impact of sharp interest rate rises on balance sheets into their stress testing of institutions ahead of periods of monetary tightening, and bring midsized banks back under the stronger Dodd-Frank rules applied to systemically important peers.

Supervisors and central banks also need to recognise the sheer speed with which an online run on the bank can develop. A 24/7 crisis requires a 24/7 response. It is no longer enough for the US Federal Reserve to limit opening of its discount window to a few hours a day. The Fed might also consider widening the range of securities that can be pledged as collateral against loans from the window and make permanent the new Bank Term Funding Program it set up in the wake of the SVB implosion.

Third, deposit insurance regimes need to be adjusted, since the perception at the moment is that all deposits are de facto guaranteed. This is delicate. A permanent backstop would increase moral hazard, giving licence to banks to pursue risky strategies. A temporary backstop of all deposits, as suggested by Sheila Bair, former chair of the US Federal Deposit Insurance Corporation, would require careful design to avoid any possible runs on fragile banks as the guarantee period drew to a close.

What is clear is that if mutualised deposit guarantee schemes’ cover widens, banks must pay a higher price to participate. Rules on the assets backing banks’ deposits must be stricter, and must be fortified against any attempts to loosen them later.

Finally, after the Credit Suisse rescue, bank supervisors must codify the investor hierarchy and ensure it is applied consistently across jurisdictions.

The SVB and Credit Suisse cases have drowned out banks’ calls to loosen the rules and should curb governments’ desire to use laxer regulation as a competitive tool. A safer, if less profitable, banking system built on fortress-like capital structures is again the goal.

But the recent turmoil is a reminder that when banks teeter, local politics and pragmatism tend to trump purism. Such ad hoc decision-making fuels further uncertainty. More than a year went by between the first credit crunch tremors in 2007 and the collapse of Lehman Brothers in 2008. Now would be a good time to reinforce the predictable framework that was meant to avoid a repeat of that crisis, before the next quake.

Source: Financial Times

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87 shares, 148 points

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