Final Reminder: Conference on Bank Resolution Mechanisms

Gregory “35%” Connor introduced an all star cast.

Ajay Chopra, now IMF Mission chief for dear old Blighty got the ball rolling.
A very important topic. Talking to an Irish audience about banking union is “preaching to the converted”. He pointed the audience to Staff Discussion note 201301 on the IMF website.

Gave an overview of the ancient past pre Lehman in the EZ when the
interbank market functioned but with big capital flows as side effects- “Procyclicality was injected into the monetary transmission mechanism and there was no possibility of controlling local interest rates”. National bank regulators controlled their own patches and cross border effects were ignored.
The shopping list was revealed .
• Banking union with a single supervisor
• a single resolution authority
• a common safety net involving
o Deposit insurance
o fiscal backstops
o burden sharing and
o a credible Lender of Last Resort

Regarding financial regulation he observed that “power and resources must go hand in hand”. I wonder why they don’t.

Some work has been done at EU level but most of this infrastructure was missing when crisis struck. It takes time to set up the banking resolution framework. It’s like building new stables while a search party is out looking for the horse.

The IMF would like to see a banking union with supervision of all EZ banks to limit the scope for regulatory arbitrage- “consistent application of prudent norms”.. “would help with the promotion of financial services in the single market”

The revised system would need appropriate checks and balances and well designed structures, in contrast to the current system. There would be open questions regarding the balance of power between the ECB and local regulators. “Oversight and accountability are required so that incentives are appropriate”.

“Responsibility requires enforcement power”. CF John Hurley

The IMF would recommend joint inspections , peer reviews and cross country teams led by ECB head. He mentioned several times that incentives must be set appropriately. Richie B’s lending targets by volume probably wouldn’t have passed.

Fortis and Dexia mop ups were very messy especially with the cross border angles. A properly staffed and resourced regulatory system would over time build up expertise and we could move away from the current ad hoc late night panic driven response that has typified the crisis to date. Hanging over the whole speech was the sense that the Irish bailout was crap and way too expensive.

“If a bank becomes unviable and is non systemic it should be resolved at least cost”. Where fiscal space is limited then the ESM should step in so that banks in trouble would have an owner of unquestioned strength. The ESM could help to stabilise prices but would not make expected losses – rather it would aim for what a patient investor would expect over time. Capital would not be injected into non viable banks.

Regarding resolution he said that a hierarchy of claims must be defined in order to reduce uncertainty around the capital structure. Insured depositors are given clear preference in legislation. The system would be prefunded through risk based premiums but in times of crisis there might be a need for the involvement of the ECB: “Of course you always need a LOLR”. “The ECB in steady state should eliminate sovereign/banks links”
http://www.youtube.com/watch?v=aMlKqSXgXTo

Legacy issues would be addressed by “creating the right incentives to identify losses. ”
A single supervisory mechanism would cover the top 3 banks in each jurisdiction. PROBLEMS WOULD BE IDENTIFIED SOONER
In some ways he sounded like an STD expert designing a system to reduce the spread of the clap.

Cyprus was an example of a situation “precisely where a banking union would have been preferable to the ad hoc method actually applied” . A least cost method could have been used with either a good bank/bad bank or direct ESM recap, the response could have been faster, it would not have had to be dependent on the national system.

He summarised by saying the mess calls for a very complex endeavour, that issues of transition as well as steady state issues need to be addressed , that actions need to be forceful and determined with a strong legal foundation and that it is important to do it properly and quickly.

The pity of it all.

Viral Acharya (New York University) “Analyzing the Systemic Risk of the European Banking Sector”

or alternatively, how to build a system to deal with a financial breakdown.

Lots of entities look like banks but are not in fact banks and regulation tends to focus just on banks/ insurance/whatever. Very little systemic overview. There are lots of organisational forms and they all need to be regulated because when TSHTF they all turn up in the market begging for liquidity (paraphrased). We need a more systemic approach.

In the case of the US with QEs 1, 2 and 3 the Fed essentially dealt with entire asset classes via its bond buying programme, swapping crap bonds for decent ones. The alternative is zombification where banks economise on capital at all costs, there is no productive lending and you wake up and suddenly a decade is lost. Head nodding ensued..

He says it’s time to start thinking about regulation in a vertical way across all holders of a particular assets- eg for bonds that would be regular banks, Investment banks, SPVs, mutual funds, pension funds, insurance cos etc.
The problem with leaving IBs or SPVs out of the loop is that in certain stress situations they’ll blow up anyway and call on the taxpayer to bail them out.

He has a book- “Regulating Wall Street” by Acharya

In his view getting taxpayers to stump up when a bank collapses is a sign of failure.

Counterparty linkages are a problem. In a common shock where everyone’s assets are banjaxed, where will the liquidity come from? In bad times counterparties may not have enough capital to soak up the assets of a bank in trouble.

And if you protect one party you have to protect them all.
He went on to discuss money markets. Who supply capital short term to banks backed by very little capital.

In 2008 in the US the money markets had $1.2 tn assets backing $1.2 tn liabilities and virtually no capital backing up the numbers.

And then the run happened. What’s a run, dude ? http://www.youtube.com/watch?v=i3Jv9fNPjgk

• Declining circulation of short term credit
• Rise in spreads
• Shortening in maturities

When there is no system wide capital available to buy certain assets such as mortgage backed securities the system is destabilized and chaos ensues.
So he introduced a history lesson . Prior to the introduction of Central Banking and fiat money, there were commercial bank clearing houses. In times of crisis deposits would not be paid immediately. They were transformed into liability certificates by the clearing houses. .
What you don’t want is a free for all. You don’t want creditors to regain their assets in a disorderly market. He suggested we need a repo clearing house.

Repo assets would be exempt from bankruptcy implications.
Now repo assets which pass through the repo clearing house may not get back 100 cents on the euro. So there may be a credit risk giving rise to the need for a LOLR.

Post Lehman was a mess because the Central Banks didn’t have the authority to sort out the problems which arose and there was loads of leakage. And very little crisis structure.

Someone asked how a money market fund could be called as such if it only gave back 90 cents on the euro. he replied the only reason that might happen would be because it invested in dodgy assets to boost yield and it would no longer be a money market fund …

In conjunction with the Chopra piece it is clear that the financial system is not designed for a future that may well be chaotic.

It all comes down to incentives and power and it does not look good.

http://www.ft.com/intl/cms/s/0/bc5dbfd6-5c89-11e0-ab7c-00144feab49a.html
http://www.ft.com/intl/cms/s/0/95cfc216-525c-11df-8b09-00144feab49a.html