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Bankruptcies, Bail-Outs & Bail-Ins: The Good, Bad & Ugly Of Bank Failure Resolution

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(Photo credit: Jagz Mario)

Are bank bailouts still official U.S. policy? Amid recent meetings of G-20 finance ministers Mary Miller, a Treasury undersecretary, insisted that U.S. policy toward insolvent banks, including the biggest, no longer includes bailouts. Really? Her remarks included this: “A common use of the too-big-to-fail shorthand is the notion that the government will bail a company out if it is in danger of collapse because its failure would otherwise have too great a negative impact. With respect to this understanding of too-big-to-fail, let me be very clear: It is wrong. No financial institution, regardless of its size, will be bailed out by taxpayers again. Shareholders of failed companies will be wiped out; creditors will absorb losses; culpable management will not be retained and may have their compensation clawed back.”

Yet in early March, Miss Miller said the Financial Stability Oversight Council (FSOC), a group of U.S. regulators tasked with preventing the next financial crisis, would vote “in the next few months” about which banks the FSOC would designate as “systematical important finance institution” (SIFI). What’s the source of this appellation, which sounds suspiciously like a perpetuation of “too-big-to-fail” (TBTF) policies? It comes from the Dodd-Frank Wall Street Reform and Consumer Protection Act” of 2010, which requires bank holding companies and non-bank financial firms with assets of $50 billion or more (19 now exist in the U.S.) to pass “stress tests” designed and imposed by the FSOC, the Fed and the Federal Deposit Insurance Corp (FDIC). Institutions deemed under-capitalized must curtail dividends, share buybacks, and acquisitions, and they also may be forced to raise additional capital. The SIFI designation has been adopted in other nations, through the Basel Committee on Banking Supervision.

So which is it? Does the U.S. still abide by its TBTF doctrine, as it did from 1982 to 2009, or has it formally terminated the policy, which abundant research, over the years, has shown to foster “moral hazard” and undue bank risk-taking?  Can anyone say definitively, whether by reference to statutory law or regulatory law, that the TBTF policy won’t be revived again, especially during the next crisis? What will be the context, then? Sheer panic – much like the last crisis – especially among officials, not the (usually) calmer public. We’ll hear that the system needs saving, that government is the savior, and that salvation will come even (and especially) if it means saving a few, large, insolvent financial institutions, because, as we heard the last time, “extraordinary times demand extraordinary (extra-legal) actions.”

Does the Dodd-Frank act, or any official regulatory provision, specifically and truly end TBTF? Dodd-Frank’s stated aim is to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” That’s pretty specific; a key goal is to “end” TBTF. But is it? Why then would a top Treasury official like Miller find it necessary, three years after Dodd-Frank’s enactment, to insist TBTF is gone, that “no financial institution, regardless of its size, will be bailed out by taxpayers again?” Perhaps officials know that most investors and policy analysts simply don’t believe it, given the government’s track record.

In truth, Dodd-Frank does not specifically forswear or prohibit a future resort to TBTF. The law surely  imposes even harsher regulations and restraints on financial institutions than had existed already before the law’s passage in 2010; and perhaps politicians and bank regulators actually believe that they are opposed to TBTF (echoing the views of most voters) only because they also tend to believe that their new rules somehow will preclude future bank failures, hence any future reliance on TBTF bailouts.

In fact, the Dodd-Frank rules probably won’t accomplish the aim of less reckless banking, any more than similar rules have done so in the past. Bank capital adequacy rules have existed for at least three decades, and still exist now because the root source of capital inadequacy hasn’t been rescinded by Dodd Frank or any other measure. The real reason so many financial institutions are highly-leveraged – the reason so many of them play it so close to the edge (of insolvency) – is that they enjoy the privilege of government deposit insurance coverage, of near-unlimited access to the Fed’s discount window, and of the TBTF policy. The only way banks feel they can maximize their return on equity is by minimizing their equity. Unless anti-equity policies are phased out, future crises and bank failures will recur. As for the next financial crisis, which will most threaten the highly-leveraged, nothing in the Dodd Frank act, or any specific regulation, precludes the Fed from once again deliberately inverting the Treasury yield curve and triggering the next recession and credit crunch, as it has done so frequently in the past.

Another, much-ignored aspect of the TBTF ambiguity is the fact that the U.S. since 1934 has granted a general immunity from bankruptcy to financial institutions. Although not widely-reported, for decades U.S. banks and other legally-favored institutions have been exempt from the U.S. Bankruptcy Code. That means an insolvent bank (or bank holding company) will also be handled politically, to some extent – whether by the Fed, FDIC, or some other agency – not commercially or judiciously, as in the court system. In effect, U.S. public policy has declared that “lenders to lenders” (i.e., the bondholders of banks) don’t have full legal rights, compared to creditors of non-banks. Clearly, this approach violates the principle of equality before the law. Here’s an account of the banks’ exemption from bankruptcy:

The section of the U.S Bankruptcy code that governs which entities are permitted to file a bankruptcy petition is 11 U.S.C. § 109. Banks and other deposit institutions, insurance companies, railroads, and certain other financial institutions and entities regulated by the federal and state governments cannot be a debtor under the Bankruptcy Code. Instead, special state and federal laws govern the liquidation or reorganization of these companies. In the U.S. context at least, it is incorrect to refer to a bank or insurer as being “bankrupt.” The terms “insolvent,” “in liquidation,” “in receivership” would be appropriate under some circumstances.

For all the criticisms of the U.S. government’s handling of bank insolvencies in 2008-2009, whether by the left (which correctly opposed the bailouts) or right (which correctly opposed the TARP’s partial nationalizations) – the consistent position of defenders of genuine, laissez-faire banking was opposition to any politicized handling of bank failures in the first place, and any subsidies. How many policy analysts today would phase out deposit insurance, the discount window, or the TBTF doctrine? It’s a minority viewpoint, for sure – but the right one. As I argued more than two decades ago, we should aim for a banking system without TBTF, but that means we need a banking system simultaneously devoid of unfair subsidies and free of overly-harsh regulations. The latter follow inexorably from the former. Bank insolvencies would become rarer in a freer system, but they’d be handled in an objective, judicious, and legal context, with careful scrutiny of creditors’ rights and the hierarchy of creditors’ claims. There’d be no question of TBTF, political favoritism, mistreatment of bondholders, or moral hazard.

What rationale has been provided for the U.S. government’s grant of immunity from bankruptcy to financial institutions? It’s been argued that since the government has become a major creditor to the banks, whether indirectly (by the provision of deposit insurance) or directly (though discount window lending, or TBTF), it can stand properly in the place of those backed, and also, that there’s a conflict of interest when the state adjudicates a case where the state is a claimant (creditor). Yet other courts have the state as plaintiff, so why not also in bankruptcy? The question is not how to handle the state as a plaintiff, but why the state has become a creditor to banks. It’s been argued, as well, that the “contagion” effects unique to banking justify quick actions and speedy resolutions, the supposed province of poised regulators, not slow-moving courts. Yet this too is a dubious claim; in all types of bankruptcy petitions judges quickly issue “stays” to preclude instantaneous or destabilizing demands by rash creditors.

The exemption of financial institutions from the U.S. bankruptcy code originated in passage of the FDIC act in 1934, when the U.S. first became a indirect creditor to the banks; the general exemption was strengthened and extended to bank holding companies by comprehensive laws passed in 1956 and 1970. For more detail on the banks’ bankruptcy exemption, see a recent, extensive account by two law professors who are skeptical and critical of the approach: “Why Banks are Not Allowed in Bankruptcy.”

There are two basic alternatives to bankruptcy for insolvent banks, each morally and practically inferior to bankruptcy: bail-ins and bailouts. In a “bail-in” a government compels depositors and/or bondholders to pay a tax and/or become equity holders in the failed institution to which they’ve lent their funds. In contrast, a government “bail-out” takes income or wealth from taxpayers in general (or from currency holders, by the hidden tax of inflation due to fiat-money creation) – most of whom have no relationship to the failed bank – to assist the failed bank’s depositors, bondholders, shareholders, and executives.

Each method entails compulsion, which is improper, and neither ensures safe or sound banking in the first place. Yet bail-ins should be more preferred, from the standpoint of justice and efficiency alike, versus bail-outs, because bail-ins involve those who’ve chosen to involve themselves with a weak or failing institution. Bail-outs, on the other hand, corral and punish innocent bystanders who are un-involved in insolvent banks. Advocates of bail-outs claim to worry about “contagion effects,” yet they push a failure resolution method which expands the collateral damage resulting from a financial fallout. In contrast, advocates of bail-ins are justified in arguing that contagion is best contained when resolution costs are restricted to those parties most related to (or responsible for) a particular financial insolvency.

That bail-ins aren’t nearly as unjust or as unjustified, on efficiency grounds, as bail-outs, is evident from the fact that some banks already secure funding through “mandatory convertible bonds” or by “cocos” (contingent convertible bonds), which automatically convert into equity if a bank weakens (becomes undercapitalized) or skirts insolvency. These securities are purchased voluntarily and their prices signal valuable, prescient information about a firm’s capital adequacy, more quickly and accurately than is possible to regulators, and they also motivate executives to rectify their bank’s financial shortcomings.

Whereas the financial-banking crisis in 2008-2009 saw the U.S. government enacting bail-outs, the financial-banking crisis in Cyprus in March-April saw the local government enacting bail-ins. The U.S. forced stronger banks (like J.P. Morgan and Bank of America) to absorb weaker, insolvent ones (Bear Stearns, Washington Mutual, Countrywide Credit, Merrill Lynch), thereby weakening the stronger ones, which weakened the whole system for the future; it made innocent parties pay, in part, for the failures. In sharp contrast, Cypriot policymakers forced the biggest depositors (creditors) of failed banks to take big “haircuts,” and minimized how much the broad population or strong banks had to foot the bill.

Unlike the bail-out approach, the bail-in method is much closer to what is observed in a true bankruptcy proceeding: the petitioner is insolvent, so haircuts of some magnitude must be suffered by the relevant creditors, but no haircuts at all are imposed on the general public, which stands outside the courtroom and is not a party to the case at hand. Yet although the U.S. bail-out approach is generally defended, the Cypriot bail-in approach is generally opposed. According to the Economist, the Cypriot resolution policy was “unfair, short-sighted and self-defeating.” A Wall Street Journal account decried the policy as “radical surgery,” such that “large depositors in Cyprus’s two big, internationally active banks absorb steep losses.” Well, someone must bear these losses. Why should depositors of an insolvent bank not bear such losses, or large depositors not bear the bulk of them? Why should losses be felt by third and fourth parties having nothing to do with the failed bank?

Also, according to the Wall Street Journal account, “the [Cypriot] deal delivered a wake-up call to regulators, investors and depositors alike about the risk of banks,” and “to some extent [the approach has] changed European policy,” because “bailing-in depositors and bondholders is now on the table when dealing with Europe’s troubled banks. The European Commission, the European Union’s executive arm, has proposed that uninsured depositors in failing banks should potentially face losses.” Well, is this not advisable, as long as the policy is announced in advance and applied consistently? Isn’t it proper that depositors and bondholders – the creditors of a financial institution – be aware of and responsible for their actions and where they commit their funds? That's what a bail-in entails. Again, why, instead, should innocents be made to suffer, as is the case with bail-outs?

Most analysts were wrong to predict that the Cypriot method of bail-ins would scare off depositors or capital investors and cause “contagion.” It didn’t happen, because the bail-in method is superior to bail-outs, which involve the exploitation of stronger banks or taxpayers, as in the U.S. approach. The Cypriot method simply tells savers and capitalists, in advance, not to expect to sit lazily and safely in some bank that’s prone to failure; they’ll be better off residing in prudent, profitable, and well-capitalized banks. It shouldn’t be so surprising, to those who recognize the incentives involved, that a study released last week by the European Central Bank, reviewing the facts in perspective, found the “Cyprus Plan Averted Contagion.”

The ideal we should be seeking is a free banking system with neither subsidies nor strictures, a system whereby banks are subject to the same laws (i.e., equality before the law) as other firms. This approach, combined with sound money and stable interest rates, would maximize our prosperity and minimize financial failures, crises, and losses. Insolvencies in banking would be handled, as in other industries, in courts of law, by reference to the bankrupt code; financial failure would be de-politicized. If U.S. policymakers aren’t willing to enact these fundamental reforms, at the least they should consider shifting from bail-outs to bail-ins. The U.S. should adopt the Cypriot method of bank failure resolution, as a step in the right direction.

Dr. Salsman is the president of InterMarket Forecasting, Inc., an investment research and advisory firm.