Deposit Insurance and Bank Insolvency Regime Reform

1
Deposit Insurance and Bank Insolvency Regime
Reform

• George G. Kaufman
• (Loyola University Chicago)
• Cass Business School (London)
• April 7, 2008

2
Why Need Reform?

• Current system of both preventing bank failures
  and resolving them, which focuses on explicit or
  implicit deposit insurance and the existing
  corporate bankruptcy code, is frequently
  inefficient, uncertain, and excessively costly

3
U.K. Focus

• Official recommendations based on failure and
  temporary nationalization of Northern Rock Bank
  and ongoing turmoil in financial markets. Focus
  on
• Deposit insurance reform
• Insolvency resolution reform (Special Resolution
  Regime SRR)

4
Basic Purpose of Current Deposit Insurance Systems

• Stop bank runs by insured parties by eliminating
  threat of credit losses (if credible)
• Limit bank fire-sale losses from runs and threat
  of technical insolvency
• Limit contagion

5
Problems with Current Deposit Insurance

• Two potential losses in bank failures
• Credit losses (PVgtRV K lt 0)
• Liquidity losses (limited access / freezing due
  to delayed sales / interruption in banking
  services)
• Shifts not eliminates depositor credit losses
• Does not address customer liquidity losses
• Encourages bank moral hazard risk-taking
• Greater portfolio risk
• Lower capital
• Encourages regulatory forbearance
• Funding not withdrawn, bank can stay open
• Thus, increases probability and cost of bank
  insolvencies in long run

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Solution to Deposit Insurance Problem

• Eliminate not shift credit losses
• Eliminate not neglect liquidity losses
• Focus on prompt legal closure at low but positive
  capital (no credit loss) and prompt customer
  access to accounts (no liquidity loss or
  interruption in services)
• Make deposit insurance redundant (but not
  unnecessary)
• Need special bank bankruptcy regime in most
  countries

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Four-Point Efficient Bank Insolvency Resolution
Program(Eisenbeis-Kaufman)

• PCA to prevent insolvencies, but with prompt
  legal closure at K gt 0 (minimize credit losses /
  least cost resolution)
• Prompt estimation and allocation of credit losses
  to uninsured claimants (enhance market
  discipline)
• Prompt sale / bridging of insolvent bank
  (minimize liquidity losses)
• Pay insured depositors par (transfer to new bank)
• Pay uninsured depositors advance dividends of
  estimated recovery amounts (transfer to new bank)
• Provide performing loan customers ongoing access
  to credit lines
• 4. Prompt reprivatization at above minimum capital

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U.S. PCA
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Four-Step Program Requires

• Fund or borrowing authority by insurer to make
  payments to depositors before final sale
• Credible PCA framework to minimize bank
  insolvencies and buy time for appropriate
  regulatory actions
• Prompt and efficient bank bankruptcy regime

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Keep Deposit Insurance on Retail Deposits

• Full and immediate protection for retail
  depositors
• Redundancy / back up
• Get small depositors off the street and at home /
  political

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Prompt and Efficient Bank Bankruptcy Regime

• Banks special / different (not bank holding
  companies)
• Even brief interruption of many activities, e.g.,
  deposit and credit access, credit cards, payments
  clearing / settlement, can have major adverse
  externality
• Avoiding adverse externalities trumps
  resurrecting bank as firm
• Prompt legal closure (minimize credit loss) and
  continuity of service with certainty (minimize
  liquidity loss) prime importance
• Corporate bankruptcy regime generally cannot
  provide above results not prompt, not
  efficient, not certain

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Case for Bank RegimeU.S. Bank and Corporate
Bankruptcy Codes
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Case for Bank RegimeU.S. Bank and Corporate
Bankruptcy Codes
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Case for Bank RegimeU.S. Bank and Corporate
Bankruptcy Codes
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Issues Regarding Regulatory Insolvency in PCA

• Legal closure at positive capital
• Taking of private property
• Rationale (bank charter, insurance)
• Residual value
• Leverage vs. risk-weighted (Basel) capital ratios
• Off-balance sheet activities
• Explicit
• Implicit

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Issues Regarding Regulatory Insolvency in PCA
(continued)

• Numerical (quantitative) value for legal closure
• High probability of economic insolvency
• Minimize credit loss
• Cost of timely and accurate monitoring
• Other (qualitative / judgment) measures of
  regulatory insolvency
• Unsafe and unsound banking
• Pending default

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Issues Regarding Regulatory Insolvency in PCA
(continued)

• Numerical trigger value (in U.S. 2
  equity/assets) mandatory floor value to limit
  forbearance
• How handle large number of concurrent
  insolvencies or near-insolvencies
• Too Big To Fail (TBTF)
• Systemic Risk Exemption (SRE)
• Noncommercial banks (e.g., investment banks)

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Why Review Past Problems and Make Case for Reform?

• Optimist Avoid repeating errors
• George Santayana (1863-1952)
• Those who cannot remember the past are
  condemned to repeat it
• Pessimist Most do remember the past George
  Kaufman (alive)
• Those who can remember the past are condemned
  to agonize first and then repeat it

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Thank you