Dealing with a problem bank

This post draws attention to two recent examples of best current practice for dealing with a problem bank that is not indispensable to the economy.

Key lessons: no need for capital injections if the bank is not going to survive; no protection for unguaranteed subordinated debt holders.  In a nutshell, the problem bank is wound up; the guaranteed depositors transferred to a strong bank.

While it is now clear that Lehman Brothers was too large and complex a bank to be wound up, this is not true of many other banks. Indeed, even since Lehmans a number of quite large banks have been intervened.  The cases of Washington Mutual and Bradford and Bingley are instructive for any authorities faced with a problem bank whose continued operation is not vital to the economy.

These banks were seen by the authorities as having no viable future, and as not being indispensible to the economy.  Their continuing business was transferred to other banks.  Government only injected sufficient funds to cover insured depositors: no new capital was needed as the rump banks were gradually being wound up.  Holders of uninsured and unguaranteed subordinated debt and preference shares faced heavy losses (they had been earning higher interest in recognition of default risk).

More detail:

On September 25th, 2008, Washington Mutual, one of the largest banks in the US, was intervened by Federal Authorities.  Its insured deposits and mortgage book was sold to the bigger bank JP Morgan Chase.  Retail customers were able to continue access their accounts the following morning and in the same old branches, but now owned by JPM.  Little or nothing was left to pay WaMu’s $22.6bn in unsecured debt, let alone the shareholders.  See: www.fdic.gov/bank/individual/failed/wamu.html

On September 29th, 2008, Bradford and Bingley, a large UK mortgage lender, was intervened by the British Authorities.  All of the deposits were transferred to Abbey National and depositors had continued access to their funds through the B&B branches, now operated by Abbey.  Mortgage holders continued to make debt service payments to B&B, now owned by the Government.  Subordinated debt holders will lose much of their investment.  See: www.hm-treasury.gov.uk/press_97_08.htm

10 thoughts on “Dealing with a problem bank”

  1. The Lehman Brothers experience raises the question, How do we know ex-ante whether a bank is systemically important? Do we have to look beyond the usual criteria such as involvement in the retail market and importance to the clearing/settlements system?
    Another issue has to do with transferring assets and liabilities from the bad bank to the good bank. It looks like JPM got WaMu’s mortgage book (assets) to match deposits (liabilities). But what if a bad bank is so bad that there aren’t enough assets (or their valuation is so uncertain) to match the deposits. How do the authorities make up the difference?
    While I’m at it, let me throw out one more thought. The FDIC has lots of experience and expertise in winding down bad banks. Does that expertise exist in this country? And are the laws in this country regarding insolvency appropriate for banks?

  2. Any shortfall would be made up by issuing government debt to the acquiring bank.

    Well it seems, from this evening’s announcement that the question is moot. The Government is to inject €1.5 billion in preference shares into Anglo Irish Bank, whose systemic importance could be questioned.

    (I would guess it’s not systemic: RTGS removes any payments system threat and, although Anglo boasts 200,000 customers it would be interesting to know how many of these also have their main transactions accounts with some other bank.)

    Crucial, now, in this recapitalization, is to try to ensure that the Government’s claim is senior to the existing unguaranteed subordinated debt — which is very sizable.

  3. According to the Govt statement, “The preference shares rank pari passu (equivalent) to ordinary shares in liquidation.” Doesn’t that render it junior to all debt including subordinated?

  4. That is the clause in the contract that needs to be changed before these preference shares are issued.

    Otherwise the €3 billion worth of existing unguaranteed preference shares will be paid first in the liquidation.

    In effect the Government’s €1.5 billion injection would, in such circumstances, go straight to the unguaranteed debtholders. Ouch.

    Now I hope you begin to see why I introduced this post! If acted on, it could save the Irish taxpayer €1.5 billion.

  5. Anglo’s Preliminary Results 2008 (first link below) shows 2,836 million of undated loan capital (page 23) as of 30 September 2008. The Government’s new stake should rank before those debts.

    I often wonder why dated subordinated debt was covered by the Government’s guarentee. In Anglo’s case, it amounts to 2,110 million. I wonder if Labour’s Eamon Gilmore ever got his answer (second link below).

    http://www.angloirishbank.com/Investors/Reports/Preliminary_Results_2008/

    http://www.labour.ie/press/listing/122346333852849.html

  6. Following on from Alan’s last comment, an interesting element in the composition of Anglo’s undated subordinated debt is that it included euro 1,812 billion of Sterling-denominated debt at the end of September . All else equal, the big slide in Sterling since then will therefore have boosted Anglo’s level of capital. However, this depends on the nature of Anglo’s currency hedges. Of course, the Sterling slide will have also reduced the euro value of its Sterling assets and its other Sterling liabilities.

    A detailed explanation of why dated subordinated debt was included in the guarantee scheme would indeed be highly welcome.

  7. I seem to recall in one of the early recapitalisations of one of the US banks that the Fed bought preference shares that were senior to all others. The result was that all existing preference shares became pretty much worthless as they would only pay coupon once the Fed had been paid. And this was an unlikely situation! This had the side effect of meaning the bank in question would not be able to raise cash by selling preference shares in future – if you are looking for private capital, this is a bad idea. No? Unfortunately, I can’t remember the name of the bank!

  8. I don’t see how this US case is relevant here. The Government’s preference shares rank equivalent with dividend claims of other preference shares. It is only in liquidation that they are rank below. Moreover, it’s hard to believe that Anglo would be able to attract private capital in any event. The Government is prepared to underwrite up to €1 billion each in AIB and Bank of Ireland, but not Anglo. No, it looks like it will be all public funds for Anglo.

  9. Yup, that’s the one. It had the result of making the preference shares worthless. Although the subsequent administration made that a moot point. I agree that it makes no difference to Anglo, but perhaps for BoI and AIB?

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