The Continued Relevance of Bank Resolution in a COVID-19 Crisis
Summary:
While the causes of this crisis are entirely different from the 2008 financial crisis, the financial sector is not insulated from the impending recession, during which higher unemployment and business closures will threaten to increase credit losses that will cause longer-term economic scarring.
In these circumstances, bank resolution regimes remain vital for ensuring financial stability and enabling weaker banks to provide the credit necessary to support the subsequent economic recovery.
While designed for a different kind of crisis, the significant levels of loss-absorbing resources large banks are required to hold to ensure orderly failure, known as Total Loss Absorbing Capacity, can aid banks when they experience stress from this crisis too.
Banks’ TLAC resources provide both recovery and resolution options to help authorities manage banks in crisis. In particular, a bank’s Board will prove much more likely to propose restructuring to its shareholders and debt holders within a wider liability management exercise if authorities can demonstrate that a bail-in of those same creditors is a credible alternative.
Indeed, resolution powers may prove invaluable in guarding against bank investors’ incentives to resist restructuring based on hopes of further Government support. Resolution powers may yet provide the authorities with an important tool for optimising how the burden of economic recovery is shared between taxpayers and investors.
Given the unprecedented levels of public indebtedness arising from COVID-19’s economic impact, the ability of resolution regimes to inhibit the unexpected contagion of losses from the banking sector to the sovereign may yet vindicate governments’ prudent efforts in having enacted such measures since earlier crises.
_____________________
2008 was a very different crisis from that now unfolding as a result of the COVID-19 pandemic. The roots of today’s economic crisis lie in the impacts of public health restrictions on the real economy, rather than the excessive leverage, mortgage asset losses, and subsequent liquidity crisis in the financial sector, as experienced in 2008. Now we face a collapse in demand throughout the real economy — not the financial markets. However, the financial sector is by no means insulated from such impacts. As the lockdown continues and a lengthy recession looms, finance, too, will encounter increasing pressure. When that happens, should weaker banks be subject to the same resolution regimes designed to impose losses on shareholders and other investors if they fail?
Governments and central banks around the world have already provided unprecedented levels of fiscal, monetary, and regulatory support to corporations, households, and the financial system. The hope therein is to avert or minimise the failure of otherwise viable corporates which will be essential to a speedy economic recovery. However, many corporates will nevertheless fail because they lack financial resources sufficient to persevere until planned economic recovery measures take effect. Layoffs, business closures, and supply chain disruption will further contribute to longer-term economic scarring.
Such conditions in the corporate sector, combined with increased unemployment, will soon begin to impact banks’ corporate and mortgage portfolios. Well before this crisis, authorities around the world had expressed concerns about unsustainably high levels of corporate indebtedness. Meanwhile, banks with high exposure to emerging-market creditors are thereby particularly at greater risk of corporate and government defaults resulting from the COVID-19 outbreak. If we suffer a “U” rather than a “V” economic recovery, the subsequent stress to some weaker banks’ balance sheets may well exceed the scenarios on which their capital and liquidity risk management frameworks are based, especially over the medium term.
Recognising this impending stress on the financial sector, regulators around the world have considered how best to ensure that banks retain the capacity for continued lending in support of economic recovery while concurrently shoring up their balance sheets to maintain financial stability. The pursuit of balance between these twin imperatives has taken the form of a wide, diverse set of measures including dividend restrictions, reduction of capital buffers, and extending deadlines for compliance with regulatory requirements.
The current crisis is unlikely to trigger bank failures in the short-term. However, bank resolution regimes remain relevant across all varieties of economic crises, whether systemic or idiosyncratic. This is so because supervisory forbearance and macroprudential tools cannot avoid all of the negative implications of economic adjustment on banks without also increasing taxpayer risk even further. Some smaller and less diversified banks may experience particularly acute stress, putting them at risk of failure in the absence of significant restructuring of liabilities, capital raising, or open-ended state support. Larger systemic banks have already begun implementing more ambitious provisions in anticipation of losses ensuing from COVID-19, and, as such, authorities consider them better prepared to weather this crisis, not least of all precisely because they have undertaken almost a decade of resolution planning. However, many large banks will face increasingly difficult credit and risk management decisions, particularly in the context of a prolonged deep recession as Governments withdraw support for the wider economy, thus increasing the risk of corporate failures, higher unemployment, and credit defaults.
One important set of questions for policymakers will focus on how significant levels of loss-absorbing resources already on banks’ balance sheets can aid banks experiencing severe stress. These resources – including gone concern debt capital and other long-term unsecured debt securities designed for crisis management purposes, known collectively as Total Loss Absorbing Capacity or “TLAC”. Authorities must, therefore, consider how their resolution tools can enable TLAC to bolster banking sector resilience alongside resolvability, ultimately so that banks can continue providing credit. This is particularly the case in developed capital-market economies where significant progress has already been made towards ensuring banks are resolvable.
Some observers are sceptical that bail-in based resolutions are effective in a systemic crisis; indeed, many are also concerned that allowing banks to enter such a resolution could exacerbate a crisis. But such fears are often based on the assumption that authorities are obliged, regardless of the market circumstances at the time, to bail-in equity and debt issued by such systemic banks at risk of failure. Regulatory capital deductions regimes, by contrast, go a long way towards addressing any risk of direct contagion to other banks while bank disclosure requirements enable institutional investors to ensure their risk management frameworks limit concentration risk to any single bank in their portfolios. However, such scepticism with respect to bail-in mechanisms sometimes fails to recognise that, if banks have improved resolvability in recent years by meeting TLAC requirements, this creates both new recovery and resolution options for the authorities to manage banks in crisis. In particular, a bank’s Board will prove much more likely to propose restructuring to its shareholders and debt holders within a wider liability management exercise if authorities can demonstrate that a bail-in of those same creditors is a credible alternative.
Ultimately, Governments and central banks providing support to the economy will find it difficult to withdraw such support if doing so risks causing corporate insolvency. Such circumstances risk creating perverse incentives for existing bank shareholders and debt-holders who may refuse to increase their support or restructure their existing positions. In such circumstances, where banks experience stress, authorities’ ability to impose losses on private investors in the event of bank failure may prove an important source of leverage and help ensure market incentives are preserved as this crisis evolves.
After the COVID-19 crisis, in a context of unprecedented levels of public indebtedness, the ability to manage the unexpected contagion of losses from the banking sector to the sovereign – for instance, via prior reliance on resolution and loss-allocation to private investors – may well remain a burden-sharing mechanism the authorities need in due course. The alternative risk of sovereign crisis would, of course, only increase the economic cost of COVID-19. Managing losses in the financial sector will better enable both governments and banks to ensure continuity of banking services to customers and credit to the real economy, both of which are necessary to hasten a wider economic recovery.
END.
Eamonn White, Director
Ardhill Advisory