BoE 2011Q3 Quarterly Bulletin

The Bank of England has released its 2011Q3 Quarterly Bulletin with the following research articles:

  • The United Kingdom’s quantitative easing policy: design, operation and impact
  • Bank resolution and safeguarding the creditors left behind
  • Developments in the global securities lending market
  • Measuring financial sector output and its contribution to UK GDP
  • The Money Market Liaison Group Sterling Money Market Survey
  • Summaries of recent Bank of England working papers
    • An estimated DSGE model of energy, costs and inflation in the United Kingdom
    • The impact of permanent energy price shocks on the UK economy
    • Evolving UK and US macroeconomic dynamics through the lens of a model of deterministic structural change
    • Preferred-habitat investors and the US term structure of real rates

I was very interested in the second article, as it contains a defense of Special Resolution Regimes relative to bankruptcy; the politicians favouring of the former at the expense of the latter is a particular hobby horse of mine:

Commencement of insolvency leads to a freeze in the bank’s ability to make payments, which effectively results in the end of its business.(2) The sudden severing of these interconnections between a bank and the rest of the financial system and wider economy can have highly undesirable systemic effects. Individuals and small companies are entitled to compensation by the Financial Services Compensation Scheme (FSCS) for the first £85,000 of their deposits. But even a relatively short delay in the time needed by the FSCS to process and pay many deposit insurance claims can lead to hardship for households and businesses left temporarily without access to their savings. Disruption of this kind can undermine depositor confidence, potentially triggering contagion to other banks and endangering financial stability.

This fear on the behalf of depositors is a red herring. The authors would have us believe that delays by the deposit insurance corporation are inevitable, while delays by Special Resolution bureaucrats are non-existent.

The legal power to transfer some or all of the business of a failed bank to another company lies at the core of the United Kingdom’s SRR and of most other bank resolution regimes around the world.[Footnote]

Footnote reads: The transfer powers are called ‘stabilisation powers’ in the United Kingdom’s SRR and a ‘purchase (of assets) and an assumption (of liabilities)’ in the United States. The United States has had a bank resolution authority since 1933 and Canada since 1967. Transfer powers have also existed in Italy for some time and have been recently adopted in Germany.

I see no reason why these transfer powers can’t be incorporated into the regular bankruptcy process as a special case for defined institutions. Given bankruptcy, the regulator steps in as receiver and splits the bank with the objective of making the “Good Bank” as small as possible consistent with the purpose of maintaining financial stability. The “Bad Bank” holds all the common shares of the Good Bank and may sell them at leisure, although it may wish to do so on the weekend. I don’t see that this is different in practice from the aims of special resolution, or inconsistent with existing bankruptcy law. All that’s needed is an adjustment to bankruptcy law allowing this to happen when (i) the failed company is a bank and (ii) the receiver is the regulator.

Creditors, such as bondholders or other wholesale funders, that the resolution authority may have decided to leave behind in the residual bank do not enjoy these benefits [of being creditors of a solvent firm]. They must claim instead for repayment of their debts in the bank’s insolvency. But as is shown in the box on page 217, a decision to split the balance sheet in a way that fully protects depositors and certain other creditors could, on the face of it, put those creditors left behind in a potentially worse position than had the transfer powers never been used and the bank had been left to go through normal insolvency.

One reason for this lies in the fact that, under UK insolvency law, depositors in the United Kingdom rank equally — or ‘pari passu’ — with other ordinary senior creditors and therefore should share any losses equally between them.[Footnote]

Footnote reads: This contrasts with some other jurisdictions, most notably the United States, where depositors rank ahead of the other creditors (so-called ‘depositor preference’).

Seems to me that if the problem is the seniority of depositors, this is most easily addressed through legislation changing the seniority of depositors. You don’t need a Special Resolution Regime to do that. Another means of achieving the same end is for the deposit insurer to put up all the funds required to cover to the insured depositors and give the insurer and the uninsured depositors a senior claim in the Bad Bank.

The authors conclude, in part:

Bank special resolution regimes are designed to address systemic risks caused by bank failure while freeing the public authorities from the dilemma of having to use public funds to bail out all of a bank’s creditors. By doing so, they offer benefits to a financial system not only at the point of use but more generally through their effect on the behaviour of banks and their creditors.

There’s nothing here that can’t be addressed by small adjustments to existing bankruptcy law. However, the most objectionable part of the article is contained in the box which describes their plans for adusting the resolution regime:

Augment the existing SRR by developing ways to restructure a firm’s balance sheet without splitting it into separate parts. There is currently much discussion around the possible use of a ‘bail-in’ tool to write down or convert into equity some classes of unsecured debt of a firm in resolution. This would enable the resolution authority to allow losses to fall on some creditors by reducing the value of their claims on the firm without having to deal with the operational and legal consequences of transferring some of the business to a purchaser. The practical benefits of such an approach may be significant articularly when dealing with large and complex banks with huge numbers of counterparties and contracts governed by different laws.

This business of giving the resolution authority the ability to change the seniority of claims in an insolvency by fiat, instead of in accord with existing bankruptcy law, is what really sticks in my craw. Discretionary “bail-in” provisions at the whim of the regulator are an affront to the rule of law.

The other article I found of interest was “Developments in the global securities lending market”, but this was a review of the topic and how it is changing, with little that was particularly new or controversial.

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