Who should pay when a bank fails?

A Bloomberg article reports that the hold up in an EU-wide bank supervisor is answering the question of who should pay when a bank fails.

Regular readers know that the answer is different if banks are 'black boxes' or they are required to provide ultra transparency.

So long as disclosure by banks leaves them resembling 'black boxes', in the short term, the losses should be absorbed by the host country taxpayers.

However, if the banks are required to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details, then the losses should be absorbed by the equity and unsecured debt holders.

Why the difference in who pays for the losses?

When bank disclosure leaves them resembling 'black boxes', investors cannot independently assess the risk of their investment.  As a result, they rely on the host country regulators' statements about the banks' financial condition.

This creates a moral obligation to bailout the investors as who are they to 'doubt' the regulators who have access to better information. [Announcing the results of stress tests in the absence of ultra transparency effectively commits the taxpayers to bailing out the investors.]

When banks are required to provide ultra transparency, investors are responsible under the principle of caveat emptor for all gains and losses.  As a result, they have an incentive to independently assess the risk of the banks.  Knowing they are on the hook for absorbing losses, investors will adjust their exposure to what they can afford to lose given the risk of each bank.

What happens if the losses on and off the banks' balance sheets overwhelm the capacity of the host country's taxpayers to absorb?

Fortunately, modern banking systems are designed to handle this problem.

Please recall that with deposit guarantees and access to central bank funding banks can continue to operate and support the real economy for years even if they have low or negative book capital levels.

It is this capacity to continue operating when a non-financial firm would be closed down that creates the opportunity to take the burden off of the host country taxpayers.  Instead of the taxpayers directly putting up the money, the money is put up through retention of future bank earnings.

This indirect way of paying for the losses reflects the simple fact that when banks have low or negative book capital levels the deposit guarantee effectively makes the taxpayers the bank's silent equity partner.

Retention of earnings is simply paying off the taxpayers' silent equity contribution.  This greatly reduces the upfront cost to taxpayers and greatly increases the resources available to absorb losses in the banking system.

But what about existing creditors and shareholders?

Existing creditors continue to be paid off.  Existing shareholders maintain their ownership interest.  However, it is likely to be several years before they see any dividends.

But given that the existing shareholders don't have access to ultra transparency, isn't it unfair to reduce the value of their investment?

No.  A shareholder would have to be clueless not to pick up a newspaper over the last 5 years and read about all the bad debt in the financial system.  They know with the lack of disclosure that they are blindly betting.

What about banks that cannot generate earnings after absorbing the losses on the bad debt they are exposed to?

These banks should be resolved.  Because of the moral obligation, at a minimum, retail investors should be made whole.

Underscoring concern in EU countries that don’t use the euro, Swedish Prime Minister Fredrik Reinfeldt said the bank plans are “complicated” and Sweden can’t be liable “for losses or problems in other countries’ banking systems.”

A French official, briefing reporters after a meeting between Hollande and Merkel, said agreements in principle were possible. He said Finland, Sweden and the U.K. were the biggest obstacles. 

With European officials saying no decisions are likely at the summit, the draft of the statement to be issued after the meeting sidesteps how the EU plans to backstop its financial system. It dropped a pledge made after their June gathering to break a cycle of banks and countries worsening each other’s woes. 

Leaders then in June made a calculated decision to start with unified bank oversight and discuss common cleanup costs later. Yet every element of the bank overhaul draws debate back to the fight over who should pay when a bank fails.