Uninsured Creditors Research Articles

Misdiagnosing Bank Capital Problems

Banks' reluctance to repair their balance sheets, combined with deposit insurance and regulatory forbearance in recognizing greater risks and losses, can lead to solvency problems that look like liquidity (bank-run) crises. Regulatory forbearance incentivizes banks to both retain risky loans and reject new good opportunities. With sufficient regulatory forbearance, partially-insured banks act exactly as if they are fully insured. Stress tests certify that uninsured creditors will be paid, not that banks are solvent, and have ambiguous effects on the efficiency of investment.

“Too‐Small‐To‐Survive” versus “Too‐Big‐To‐Fail” banks: The two sides of the same coin

AbstractIn the recent crisis, the U.S. authorities bailed out numerous banks through TARP, whilst let many others to fail as going concern entities. Even though both interventions fully protect depositors, a bail out represents an implied subsidy to shareholders, which is not yet the case with closures where creditors are not subsidised. We investigate this non‐uniform policy, demonstrating that size and not performance is the decision variable that endogenously determines one threshold below which banks are treated as TSTS by regulators and another one above which are considered to be TBTF. We, hence, provide a pair of economic rather than regulatory cut‐offs for TBTF and TSTS banks. The shareholders and the other uninsured creditors of a distressed bank are not bailed out if the bank is considered to be TSTS. We further document that the less complex a bank is, the less likely is to be bailed out and, hence, to have all of its creditors protected.

Interbank Network and Bank Bailouts: Insurance Mechanism for Non-Insured Creditors?

This paper presents a theory that explains why it is beneficial for banks to be highly interconnected on the interbank market. Using a simple network structure, it shows that, if there is a non-zero bailout probability, banks can significantly increase the expected repayment of uninsured creditors by entering into cyclical liabilities on the interbank market before investing in loan portfolios. Therefore, banks are better able to attract funds from uninsured creditors. Our results show that implicit government guarantees incentivize banks to have large interbank exposures, to be highly interconnected, and to invest in highly correlated, risky portfolios.

Durchsetzung von Marktdisziplin mittels zwangsweiser Übertragung systemrelevanter Teile von Banken? / The Enforcement of Market Discipline through a Transfer of Systemic Functions in Banks

Zusammenfassung Die aufsichtsseitig erzwungene Übertragung von Vermögenswerten und Verbindlichkeiten von insolventen Banken auf privatwirtschaftliche Erwerber oder sog. Brückenbanken hat sich weltweit schon vor der globalen Finanzkrise als funktionale Alternative zu traditionellen Insolvenzverfahren etabliert. In Auseinandersetzung mit den Lehren der Krise ist das Instrument in zahlreichen Rechtsordnungen und auf der Ebene der internationalen Standardsetzung geradezu als „best practice“ anerkannt worden und ist auch Bestandteil der geplanten EU-Richtlinie über die Sanierung und Abwicklung von Kreditinstituten und Wertpapierfirmen. Der vorliegende Beitrag unterzieht derartige Übertragungsinstrumente einer kritischen Würdigung und geht der Frage nach, ob sie - im Unterschied zu traditionellen Formen der Insolvenzbewältigung - auch bei systemrelevanten Banken die Haftung von Anteilseignern, Geschäftsleitern und Gläubigern und damit ein anreizkompatibles Regime sicherstellen können, das den Funktionen des klassischen Insolvenzrechts gerecht wird. Er gelangt zu dem Ergebnis, dass dies angesichts zahlreicher technischer und konzeptioneller Schwierigkeiten allenfalls im Zusammenwirken mit anderen Mechanismen, z.B. einer zwangsweisen Rekapitalisierung im Wege eines „bail-in“ von Gläubigerforderungen, gelingen kann.

A Year of Living Dangerously: The Management of the Financial Crisis in 2008

There are many reasons to regret the decision of U.S. financial authorities to insert the government into the resolution of the investment bank Bear Stearns in March 2008. The Federal Reserve's use of its discount window built up false hope of future rescues. Paying off the uninsured creditors of Bear Stearns overcompensated them at the time and invited speculative attacks on the equity of similarly situated firms. I will argue that the market seizure after Lehman Brothers' decision to seek the protection of bankruptcy was an echo of the prior official decision to protect Bear Stearns.

The Squam Lake Report: Observations from two policy professionals

The Squam Lake Report (SLR) contains a host of recommendations to “fix the financial sector.” A credible fix must take on the excessive risk-taking of financial institutions created when uninsured creditors of important financial institutions expect government protection from loss (i.e., the too-big-to-fail problem). The vast majority of SLR’s recommendations constitute important contributions to addressing TBTF; the analysis offered in support of recommendations is sound and brings modern economics and finance to bear. The clarity and focus of SLR offers a model for academics writing for a policy audience. We differ in emphasis with SLR on a few issues, including capital and living wills, but support moving forward with the core of SLR’s recommendations even in these cases. Legislation (i.e., “Dodd–Frank”) seeking to fix the financial sector became law around the time SLR was published. The legislation includes in one form or another the predominance of credible recommendations made to address TBTF, including the majority of those in SLR. The ultimate success of the legislation, however, depends on implementation. We hope the government focuses on a macroprudential regime that reduces fallout from financial spillovers, considers new efforts to measure and tax expected TBTF subsidies, and reconsiders aspects of Dodd–Frank that expand the safety net. Given the stakes, another SLR-caliber effort, this time centered on Dodd–Frank implementation, promises high returns.

The Optimal Level of Deposit Insurance Coverage

This paper develops a global game model that allows for a rigorous analysis of partial deposit insurance and provides the first comparative statics of the optimal level of deposit coverage. The optimal amount of coverage increases with lower bank liquidity requirements, with a higher precision of depositors’ information, and with a lower relevance of large, uninsured creditors, and it should not be increased in anticipation of an economic downturn. Optimal insurance is higher if there is contagion and lower if banks can assume excessive risk, but interestingly, a high level of coverage may not be optimal even in the absence of moral hazard on the part of banks. The model supports the inauguration of coinsurance provisions and is applied to compare various policies addressing financial fragility. While an optimal lending of last resort policy can outperform deposit insurance, anticipated bailouts are inferior in terms of welfare. Capital requirements are not a substitute for insurance, but mitigate excessive risk taking.

Discipline and Liquidity in the Interbank Market

Using 20 years of panel data, I demonstrate that high‐risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid‐1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank‐market price discipline roughly doubled, and risk‐based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions.

On the Resolution of Banking Crises: Theory and Evidence

This paper reviews the merits of the various techniques used by authorities when resolving individual or widespread bank failures in developed and emerging market economies. In particular, the various banking crisis resolution techniques available to the authorities are classified and then compared with the techniques that have been used in practice, drawing on both the available evidence and our own analysis. With individual bank failures the authorities usually first seek a private sector solution. Any losses are passed on to existing shareholders, managers and sometimes uninsured creditors, and not to taxpayers. But policy options are more limited in systemwide crises. In most recent systemwide crises, early on central banks have provided liquidity to failing banks and governments have given blanket guarantees to depositors. In nearly all cases, investor panics have been quelled but at a cost to the budget and increasing the risk of future moral hazard. Open-ended central bank liquidity support seems to have prolonged crises, thus increasing rather than reducing the output costs to the economy. Bank restructuring has usually occurred through mergers, often government assisted, and some government capital injection or increase in control. Bank liquidations have been rare and creditors - including uninsured ones - have rarely made losses. In systemwide crises, resolution measures have been more successful in financial restructuring than in restoring banks' ongoing profitability or credit to the private sector. In most cases bank lending has remained subdued for years after a banking crisis.

Discipline and Liquidity in the Market for Federal Funds

I find that high-risk banks pay more for federal funds and are less likely to utilize them as a source of liquidity. The extent of this discipline has risen in recent years, following legislation designed to impose more of the costs of bank failure on uninsured creditors. However, the risk-pricing remains imperfect, and additional results suggest that information problems persist in the fed-funds market. The findings have implications for interest-rate determination, risk contagion in the financial system, the use of market data in banking supervision, and recent efforts to reform Discount Window operations.

Did FDICIA Enhance Market Discipline? A Look at Evidence from the Jumbo-CD Market

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) forced uninsured creditors such as jumbo-CD holders to bear more of the losses from bank failures. Because no other federal laws affecting loss exposure took effect in the surrounding years, the Act offers a natural experiment for assessing the supervisory returns from greater reliance on debt markets to police bank risk. Accordingly, we examine the sensitivity of jumbo-CD yields and run-offs to risk before and after FDICIA as well as the implied impact of any risk penalties on bank profitability. The evidence indicates that yields and run-offs were risk sensitive in both periods, but that this sensitivity was always economically small and, more importantly, was not significantly higher after the Act. These findings suggest that raising the deposit-insurance ceiling would not - at least in the current institutional and economic environment - exacerbate moral hazard. More importantly, they also suggest that operationalizing debt-market discipline as pillar of bank supervision could prove more difficult than previously thought.

ARE SOME BANKS TOO LARGE TO FAIL? MYTH AND REALITY

At the time of the Continental Illinois National Bank insolvency, bank regulators considered some commercial banks “too large to fail” (TLTF) and were reluctant both to legally fail such banks and to impose pro rata losses on any of the uninsured creditors of these insolvent banks and their parent holding companies. This policy was introduced due to widespread fears that large bank failures would set off a domino effect bringing down other banks and possibly even the macroeconomy as it did during the 1930s. Also, because these banks are considered special in that they provide money and credit to their communities, many feared that their failure could reduce greatly the availability of these services.This paper analyzes the validity of these fears by examining both theory and the historical record. It concludes that neither theory nor history provides strong support for either fear. In addition, the paper finds that the costs of regulatory forbearance granted to insolvent banks and their creditors greatly exceed the alleged benefits. It also reviews how policy makers apply the TLTF principle in practice. The paper concludes that the policy has been modified progressively over time so that some large banks now are declared legally insolvent and all creditors of bank holding companies—and some uninsured creditors of the banks themselves—incur losses. One may reasonably expect that TLTF will be modified further as the large societal costs become more evident to the public and regulators alike.

REFORM OF THE DEPOSIT INSURANCE SYSTEM: AN APPRAISAL OF THE FHLBB AND FDIC STUDIES

This paper presents an appraisal of the studies of the deposit insurance system submitted to Congress by the Federal Deposit Insurance Corporation and the Federal Home Loan Bank Board in compliance with the Garn‐St. German legislation of 1982. The purpose of these studies was to assess the current structure of the deposit insurance system in light of the changes in the regulation of depository institutions mandated in recent legislationMany observers of the financial system believe that, as a result of recent regulatory changes, the deposit insurance agencies do not have sufficient power to control risk‐taking of insured institutions. These two reports present an assessment of mechanism which could be used to limit the risk of the deposit insurance agenciesThe emphasis in both reports is on ways in which the amount of market discipline applied to insured institutions could be increased. Both reports identify essentially three ways in which this might be accomplished. First, risk‐adjusted deposit insurance prices might be employed. Second, the volume of uninsured creditors might be increased, either through changes in limits of insurance coverage or through imposition of requirements for use of subordinated debt. Third, the current public deposit insurance system might be partially supplanted by one that is private. This paper evaluates the merits of each of these proposals and compares the positions taken by the FHLBB and the FDIC on the issues