SRB-FBF-SAFE academic event: Bank crisis management – what next?

Last week saw the virtual conference on Bank Crisis Management – What Next?, jointly organised by the Florence School of Banking and Finance, SAFE Frankfurt and the Single Resolution Board, with seven papers covering a wide range of topics related to the title of the conference and a keynote lecture by Manju Puri who – among many other jobs and honours – was at some point Chief Economist of the FDIC. A short summary of the papers, with some (maybe provocative) policy conclusions.

Diana Bonfim and João Santos show the importance of deposit insurance credibility, i.e., the importance of a credible sovereign backstop, using data from Portugal and exploiting the fact that some foreign banks changed their status in Portugal from subsidiary to branch status during the European sovereign debt crisis, which implies that their Portuguese deposits became subject to the deposit insurance scheme of countries with lower sovereign risk. They show an increase in deposits after the shift in status, suggesting that depositors do care about the credibility of their deposit insurance and thus sovereign backstop. An argument for European deposit insurance to break the link between banks and sovereign and move towards a truly European market in banking.

Christian Muecke and co-authors gauge the effect of a disciplining tool in the US to ‘convince’ bailed-out banks during the Global Financial Crisis to pay dividends to Treasury on its capital injection: pay up or accept Treasury-appointed board members; specifically, if a bailed-out bank missed six quarterly dividend payments, the US government had the right to appoint independent board members. The incentive was effective as many banks missed no more than five dividend payments (maximum before the appointment of board members) but also the stick helped, as board appointments by the Treasury helped improve bank performance and reduce risks. Results clearly show that incentives can work in crisis resolution and that bailout funds should not be given without conditions.

Mathias Dewatripont and co-authors discuss to which extent the resolution model of Single Point of Entry (SPE) (where losses are upstreamed to the parent bank, while capital is downstreamed to subsidiaries if needed) can counter regulatory incentives of host authorities to ringfence a subsidiary during times of crisis. They argue that an SPE model is not sufficient, as the regulatory authorities of subsidiaries have a legitimate incentive to maintain measures to safeguard the corporate interest of subsidiaries as long as the support to be expected by the parent company remains uncertain. What is needed is (i) the formalisation of the nature of the parent support through a burden sharing agreement and (ii) the introduction of a hierarchy of creditors within groups, which would be aligned on the implicit hierarchy of creditors prevailing under the SPE strategy. Another strong argument illustrating that the to Banking Union in capitals is far from complete.

Alessandro Scopelliti and co-authors focus on the introduction of bailinable bonds, an important component of regulatory reforms in the last decade aimed at reducing the likelihood of future bailouts. Exploiting granular data on banks’ securities holdings they find that banks hold more bailinable bonds issued by other banks and issued by other parts of same group. In addition, there is a clear home bias, as banks hold primarily bailinable bonds by other banks in the same country. . Clearly not what was intended and an indication of an incomplete reform!

The paper by Orkun Saka and co-authors explores governments’ financial sector policies after crises. They show that financial crises can lead to more government intervention and a process of re-regulation in financial markets. However, some of these interventions might not necessarily be in the public interest, as democratic leaders who do not have re-election concerns are substantially more likely to intervene in financial markets after crises, in ways that promote their private interests, with pay-offs in the form of financial sector jobs after their government tenure. Lesson: Post-crisis reforms are important, but it is crucial to consider the incentives of those who propose and implement them.

Sascha Steffen and co-authors explain the heavy decline in banks’ stock prices during the early part of the pandemic. They show that the decline in banks’ stock return during Covid-19 is primarily driven by liquidity risk. Specifically, stock prices of banks with large ex-ante exposures to undrawn credit lines and large ex-post gross drawdowns declined more, especially of banks with weaker capital buffers. This also had consequences for banks’ behaviour as these banks reduced new lending, even after stabilization policies and even if drawdowns were accompanied by deposit inflows. Clearly a justification for the increasing focus on liquidity in addition to solvency risk in banks.

Miguel Faria and co-authors show the macroeconomic consequences of evergreening of bad loans by banks, using both theory and empirical evidence with loan-level data from the US: low-capitalized banks systematically distort their risk assessments of firms to window-dress their balance sheets and extend relatively more credit to underreported borrowers, with negative economic consequences, in the form of lower firm entry and lower aggregate productivity. Clear evidence of distortive incentives provided by low bank capital and the negative consequences of zombie lending!

Finally, in the keynote lecture, Manju Puri discussed the role of private equity (PE) investors after the 2008 crisis. Using proprietary failed bank acquisition data from the FDIC combined with data on PE investors, she and her co-authors find that PE investors made substantial investments in underperforming and riskier failed banks and where there are few healthy banks as alternative acquirers. They find a positive impact of PE acquisition on bank performance and local economic recovery. . While the results are for the US, an interesting and important lesson for Europe, where we still have a steep learning curve ahead of us in terms of bank resolution.

The recording of the event is available here.

Interested in learning more about resolution? The registrations to our next online Bank Resolution Academy are open. You will find all the info here.

November 26, 2021 News