Hierarchy for resolving bank insolvency

The bail-in of uninsured depositors in the Cyprus banks highlights the need to establish a global hierarchy for resolving insolvent banks.

Your  humble blogger would suggest the following hierarchy for apportioning the pain of recapitalizing the bank or absorbing the losses.

1. Future earnings generated by the bank;
2. Common stock holders;
3. Preferred stock holders;
4. Junior unsecured bondholders;
5. Senior bondholders;
6. Uninsured depositors;
7. Host country taxpayers through the deposit guarantee;
8. Foreign taxpayers.

What distinguishes this hierarchy is that it explicitly recognizes that a bank can transition between solvency and insolvency and back to solvency as the market value of its assets changes between greater than to less than to greater than the book value of its liabilities.

As I describe in an earlier post explaining why a bank never needs to be bailed out, we can determine if a bank has a viable franchise by looking at whether its assets after recognizing its losses on its excess debt exposures generate enough interest income to exceed the interest expense on its liabilities.  

If interest income exceeds interest expense, the bank franchise is viable and the bank can generate the earnings to rebuild its book capital levels.  If interest income is less than interest expense, the bank should be resolved.  It is only then that we go past step 1 in the hierarchy.

Naturally, bankers are going to fight against adoption of this hierarchy.  The reason they will fight adoption is that it puts the pain for the losses currently hidden on and off the bank balance sheets directly on the bankers.

Specifically, while a bank is generating earnings to absorb the losses, banker pay is likely to be highly restricted.  As oppose to the current situation where taxpayers are absorbing the losses and bankers are paying themselves near record levels of pay.

Of course, from the standpoint of everyone lower down in the hierarchy, including taxpayers, they prefer to maximize the amount of future earnings generated by the bank that are used to absorb the losses.

This preference for maximizing future earnings to absorb losses highlights a critical issue:  how quickly do banks need to be recapitalized after they become insolvent?

A modern banking system is designed so that banks can operate for years, even decades, with low or negative book capital levels.  

Banks can operate and support the real economy as a result of the combination of deposit guarantees and access to central bank funding.  With deposit guarantees, taxpayers effectively become the banks' silent equity partner when the banks are in the process of generating earnings to rebuild their book capital levels. 

Regular readers know that to prevent bankers gambling on redemption to restart their bonuses sooner and to ensure that banks absorb all the losses on the excess debt in the financial system, banks must provide ultra transparency.  With disclosure of the banks' current global asset, liability and off-balance sheet exposure details, market participants can exert discipline on the banks to clean-up their exposures and restrain their risk taking.

But what about the fact that banks are going to have negative or low levels of book capital?

It is the deposit guarantee that makes bank book capital levels irrelevant to insured depositors.  A lesson learned from their parents when they opened up their first bank account as a child and asked how could they trust that the bank would give them their money back.

Yes, uninsured depositors, bondholders and stockholders are going to be concerned about the level of book capital.  The low level is a source of market discipline as it gives them a vested interest in making sure that banks minimize their risk while rebuilding book capital levels.

But if banks have low or negative book capital levels, how can they support the real economy by lending?

A distinction must be made between a bank's ability to originate a loan and its ability to fund the loan on its balance sheet.

Banks can always originate loans.  When they are rebuilding their book capital levels, they are restricted in their ability to fund the loan on their balance sheets.

This is okay because banks can always sell the loan to investors like insurance companies, pension funds, hedge funds and better capitalized banks that would like to hold the loan.