Bank resolution costs, depositor preference and asset encumbrance

Abstract

Purpose – This paper aims to clarify the effects of introducing depositor preference on resolution costs, probability of default and bank funding costs, allowing for the possibility of collateralized funding. Design/methodology/approach – The importance of conflict among creditors in generating bankruptcy costs is documented. A model of such a conflict is provided, which is then used in analyzing the effects of depositor preference and other forms of asset encumbrance. The model takes into account the reactions of providers of secured and unsecured financing. Findings – Depositor preference and collateralization of borrowing may reduce the cost of settling the conflicts among creditors that arises in case of resolution or bankruptcy. This net benefit, which may be capitalized into the value of the bank rather than affect creditors’ expected returns, should result in lower overall funding costs and thus a lower probability of distress despite increasing encumbrance of the bank’s balance sheet. The benefit is maximized when resolution is initiated early enough for preferred depositors to remain fully protected. Research limitations/implications – The interaction of asset encumbrance with liquidity risk is not addressed directly. Practical implications – The issues addressed on the paper are currently the subject of debate by regulators and market participants. There are direct implications for prudential regulation and bank resolution policies. Originality/value – The theory of conflict resolution is applied to bankruptcy and bank resolution, generating rigorous analysis of an important practical issue.