|
|
|
|
|
Comment
07 March 2010 By Colm McCarthy
Recent statements from the Minister for Finance and the Central Bank governor make it clear that the phoney war phase in the Irish banking crisis is drawing to a close.
The transfer of assets to Nama will crystallise such substantial bank loan losses that recapitalisation will be unavoidable.
Governments around the world have responded to the insolvency of banks in a variety of ways. Many have guaranteed certain liabilities, injected equity and purchased distressed assets.
Where suitable legislation was in place, failing banks have also been ‘resolved’ – that is, placed in a special insolvency process by the authorities.
Individual bank failures are common, and systemic failures of entire banking systems have occurred frequently around the world. Why not treat failing banks the same as any other corporate insolvency, placing them in administration or receivership?
Shareholders, other providers of risk capital and ordinary creditors would be placed in an orderly queue, paid whatever portion of their claims can be afforded and the business closed down or restructured under new ownership. This happens all the time to troubled companies in other sectors.
The difference is that the wider economic and social consequences arising from widespread or systemic bank failure are potentially very damaging, and governments seek to prevent such failures and create a statutory framework to minimise the fallout when it occurs. Thus, the ordinary insolvency legislation which applies to limited liability companies is not suitable for banks.
Corporate insolvency procedures kick in after solvency has been lost. With banks, in order to avoid bank runs and contagion effects on other solvent banks, it is desirable that imminent failure be preempted prior to actual insolvency which, in any event, can be difficult to distinguish from illiquidity.
In September 2008, numerous solvent banks became illiquid, as the money markets seized up after the collapse of Lehman Brothers. Central banks furnished lavish liquidity support, but some banks, including Irish ones, proved to be insolvent as well as illiquid, and had to be closed, nationalised or restructured.
Central banks have been providing temporary liquidity to illiquid banks since the 19th century, a necessary support to avoid the externality of bank runs and contagion. But the provision of liquidity to banks already insolvent is undesirable, not least because their managements are enabled to ‘gamble for resurrection’ – that is, pursue risky strategies with negative expected value, at cost to the taxpayer.
The government needs to do more than ensure bank recapitalisation. It needs a full exit strategy, which includes the ultimate withdrawal of the liability guarantee regime, presumably to be replaced by some more limited form of insurance for depositors. If regulation and supervision are strengthened, the risk of a future banking collapse is reduced – but never eliminated.
So there also needs to be bank resolution legislation, which would empower the Central Bank to take over the management of any bank deemed in danger of failure, and to restructure or wind down the institution.
Creditors other than insured depositors would see their claims satisfied to the extent feasible given the bank’s financial condition.
There are many models for such legislation, including the Banking Act of 2009 in Britain and the long-established arrangements for resolving failing commercial banks in the US. The problems with Bear Stearns and Lehman in the US arose because these were Wall Street banks not covered by the bank resolution regime.
The impression that governments were making it up as they went along in dealing with the post-Lehman fallout owes much to the absence of workable bank resolution statutes.
Ad hoc solutions and excessive taxpayer cost, arising from inability to conduct orderly wind-downs, are likely where no solution short of bankruptcy is available to the authorities. In Britain, the authorities were unable to force Northern Rock into a resolution procedure in 2007, even though the run on the bank threatened financial stability.
They were eventually forced to nationalise, with consequent taxpayer exposure. In Ireland in September 2008, the options open to government in dealing with the failure of Anglo Irish Bank were constrained by the absence of resolution options.
In the US, the extension of the (commercial) bank resolution regime to institutions not currently classified as banks – notably, the surviving Wall Street investment firms – awaits legislation still wending its way through Congress. Former treasury secretary Hank Paulson, the man who engineered the rescue of Bear Stearns (and passed on Lehman), noted recently: ‘‘Amazingly, US government regulators still lack the power to wind down a non-bank financial institution outside bankruptcy." In Britain, the 2009 Banking Act has already come into effect.
In addition to the completion of bank recapitalisation, the Irish government needs to construct a resolution regime for failing financial institutions, distinct from ordinary corporate insolvency procedures.
In addition to banks, it should, perhaps, cover other financial institutions whose failure could require a state financed rescue. The principal candidates are insurance companies. The US government had to bail out AIG, an insurer that was deemed systemically important to the entire system. In Ireland, the biggest financial failure prior to the current disaster was the collapse of the PMPA insurance company in the 1980s.
It is salutary to note that policyholders have been picking up that tab through a levy until quite recently. Failing banks tend to signal the fact through liquidity problems, but insurers get paid premiums in advance, and can be liquid, as well as insolvent. The next costly failure in Ireland does not have to be a bank.
The wide-ranging guarantee of bank liabilities announced at the end of September 2008 runs out in little more than six months. Assuming that the banks have been recapitalised by then, the government can minimise subsequent risk of exchequer cost through getting out of the guarantee business as quickly as possible.
Bank resolution legislation – clarifying the power of the authorities to ensure that all providers of risk capital share quickly and appropriately the losses incurred by failed banks – is an important component in the state’s exit strategy from the banking collapse.
Colm McCarthy lectures in economics at UCD
|
|
|
