How to rescue a bank without regret

By: Reint Gropp and Jan Pieter Krahnen

During the recent financial crisis almost all bank rescue operations followed the same myopic script:  once a troubled bank reports its troubles, a rush for resurrection sets in, frequently on a Friday evening after close of business. The authorities have only two and a half days, from Friday to Sunday, to find a workable solution. On Monday morning, before the opening of the markets on the other side of the globe, a water-tight rescue plan has to be presented to the public. More often than not, the bank will be bailed out with public money. This rewards excessive risk taking and weakens the position of the bank’s competitors. Both effects decrease social welfare and financial stability over the medium term. At the same time, the seeds for the next crisis are planted.

Governments around the world are aware of this problem, but they claim that bail-outs of troubled banks are inevitable to avoid systemic risk. So can we stabilize a financial institution without undermining competition and rewarding excessive risk taking? We believe that a fundamental, although straightforward policy change can do the trick. It is based on the simple idea of rewarding strong institutions in order to rescue weak ones: Rescue without regret.

The proposed reverse bailout policy brings strong banks in a position to take a lead in resolving the failure of competitors. Hence, strong banks rather than weak banks are rewarded with additional conditional capital in times of crisis. Suppose, for example, the government provides the strongest bank in a country with fresh capital, if a sufficient number of banks in the banking system are in serious trouble. “In trouble” may mean that banks fall short of a critical capital threshold, or that refinancing is in peril. The fresh equity capital enhances the strongest bank’s risk capacity, enabling it to take over failing weak banks, or at least parts of their business. Or they may simply purchase troubled assets from failing institutions, thereby preventing a market-wide downward spiral of the prices for these assets.

Such a reverse bailout policy would address both side effects of existing bail out policies.. It would reward banks that incur less overall risks, and in particular those less exposed to systemic risk, rather than the opposite as under current standard policies in most countries. Clearly, the provision of fresh equity to the strongest competitors would have to be conditional. The conditionality could take different forms, one example being the obligation of the receiving bank to only use the newly acquired equity for a purchase of assets, or entire lines of business from the failing bank. It may also have an expiration date. So, if it remains unused it would be available as equity injection in the traditional way, supporting the failing banks.

How should a reverse bailout be financed? For the financing not to rely on tax money, the funds have to be large enough to cover a potential systemic rescue operation. The levy should reward those institutions that contribute little to systemic risk, while it penalizes banks with high contributions to overall systemic risk, thereby inducing the industry to self-monitor its level of systemic risk.

In normal times, a systemic risk charge could be levied upon all financial institutions. It would be similar to an insurance premium. The amount is determined either by a national banking supervisor, the European Systemic Risk Board, or a national or European deposit/liability insurance corporation. Let’s call it the “Systemic Risk Fund”. The systemic risk charge is a premium paid by each institution, proportional to its overall contribution to systemic risk.

The annual premiums  will then be re-invested by the Systemic Risk Fund in the very institutions that had paid these charges. This re-investment may take many forms. We favour the use of contingent convertible “systemic risk” bonds, which would constitute long term liabilities against the Systemic Risk Fund. These would initially not be recognized as equity by the supervisory agency, and represent a long-term capital buffer in each financial institution. Due to their nature as convertibles, they can perfectly fulfil the rescue role prescribed earlier: in case of a crisis, when weak institutions get into trouble, these convertible instruments will be ‘triggered’ by the supervisory authorities. At the same moment the debt position is converted into equity, the interest paid on debt is eliminated, with an immediate effect on the institution’s cash flow. Due to both, the capital effect and the liquidity effect, strong institutions have the ability to bid for the failing bank, taking it over, or liquidating the failing banks’ assets. The strong banks are put in a position to assume the role of buyers in markets where under present bailout policies there are only sellers. This stabilises market prices, reduces knock-on effects to other banks and reduces the effects of financial crises on the real economy.  

Reint Gropp is Professor of Financial Economics and Taxation, European Business School, Oestrich-Winkel. Jan Pieter Krahnen is Professor of Finance at Goethe University Frankfurt.

 

---