The Economist had an interesting article recently co-written by Credit Suisse's investment banking head Paul Calello and former chief risk officer Wilson Ervin. They suggest that, rather than bail out banks in the future, they could be "bailed-in." What does that mean? Essentially that regulators could take hold of troubled banks and require them to rework their capital structure to avoid failure. It would sort of work like a pre-packaged bankruptcy. The idea makes sense, but I wonder: isn't this exactly what a new resolution authority would do?
We all remember how Lehman tried to avoid bankruptcy, but failed. The authors give a lengthy explanation of how a so-called bail-in would have worked in that case:
How would it have worked? Regulators would be given the legal authority to dictate the terms of a recapitalisation, subject to an agreed framework. The details will vary from case to case, but for Lehman, officials could have proceeded as follows. First, the concerns over valuation could have been addressed by writing assets down by $25 billion, roughly wiping out existing shareholders. Second, to recapitalise the bank, preferred-stock and subordinated-debt investors would have converted their approximately $25 billion of existing holdings in return for 50% of the equity in the new Lehman. Holders of Lehman's $120 billion of senior unsecured debt would have converted 15% of their positions, and received the other 50% of the new equity.
The remaining 85% of senior unsecured debt would have been unaffected, as would the bank's secured creditors and its customers and counterparties. The bank's previous shareholders would have received warrants that would have value only if the new company rebounded. Existing management would have been replaced after a brief transition period.
The equity of this reinforced Lehman would have been $43 billion, roughly double the size of its old capital base. To shore up liquidity and confidence further, a consortium of big banks would have been asked to provide a voluntary, multi-billion-dollar funding facility for Lehman, ranking ahead of existing senior debt. The capital and liquidity ratios of the new Lehman would have been rock-solid. A bail-in like this would have allowed Lehman to open for business on Monday.
So essentially, you wipe out current shareholders and convert a portion of debt to equity. Then hope banks provide (a lot of) liquidity. A few comments.
First, the authors don't see why bankruptcy code can't do this today. Here's their answer: it can, but not quickly. That's what bankruptcy proceedings are for, and they can last years. Clearly, that's not an option if you want to avoid a disastrous financial crisis. The authors want to streamline the process; well, I do too. And that's the whole concept behind a non-bank resolution authority. It would require "failure plans" from large institutions that would anticipate how to handle bankruptcy. Indeed, a firm's failure plan could look exactly like this. With the new regulator, this would be possible. But for now, it isn't. Once in place, it may wind-down some institutions if their problems are too great to keep them afloat, but in other instances it could rely on plans like this for reorganization.
My biggest concern with this idea is liquidity. I'm a little less confident than the authors that banks would get in line to provide billions of dollars in cash to their troubled brethren. After all, we're talking about a market where a credit crunch is probably underway. And liquidity is a significant problem for a bank that runs into trouble. I remember talking to people who worked at Lehman in 2008 about how, internally, people were worried about the firm making payroll in its final weeks.