22/8/2013: Bank Resolution Costs, Depositor Preference, and Asset Encumbrance: IMF Paper

Daniel Hardy's paper "Bank Resolution Costs, Depositor Preference, and Asset Encumbrance" (July 2013, IMF Working Paper No. 13/172. http://ssrn.com/abstract=2307415) looks at the banks resolution structure from the point of view of costs of bankruptcy / debt restructuring arrangements.

Hardy states that "bank resolution, like bankruptcy and debt restructuring generally, inherently involves a great deal of negotiation and uncertainty…" Based on the experience, especially from the current financial crises, conflicts arising from bankruptcy or restructuring "…can add substantially to costs and delays in resolution".

To mitigate such costs, Hardy suggests, the regulators can "make some claims bankruptcy remote" via "statute and policy, as when depositors enjoy preferred status as a matter of law, or through private agreements, as when banks issue covered bonds backed by a pool of high-quality assets."

Because such 'remoteness' reduces conflicts resolution costs in the case of restructuring or bankruptcy, "the asset encumbrance that results from either mechanism can be desirable insofar as it reduces bankruptcy costs, and, through lower overall funding costs, lowers the probability of distress."

The effects of remoteness are multiple and interactive:

1. "…the gain should be capitalized into the value of the bank, which enjoys an overall reduction in funding costs." 
2. Non-secured borrowers need not "be disadvantaged in expectational terms: they earn more when the bank survives but bear larger net losses in case of resolution (though they spend less contending for their claims)."
3. "Granting preferred status to (some) depositors need not provoke increased collateralization of other credits: from the point of view of the borrowing bank, collateralization and statutory depositor preference are near substitutes…" 

Note 1: point 3 above establishes non-zero value of depositors. Recall that collateralisation is the source of funding. It represents a liability on the balance sheet, but such liability is cost-reducing. Cost savings arising from collateralisation as (1) decreasing in volume of collateralisation, and (2) have a positive value the bank. Deposits-related cost savings are not decreasing in volume (no marginal pricing) for a small-medium bank (although they might be increasing for a larger bank). This is the fundamental difference in pricing of deposits.

Note 2: limited depositor guarantee schemes (DGS), consistent with the above structure (1)-(3) would be required to remain stable, with the limits of protection not subject to alteration downward in the case of the crisis.

Now, back to the paper.

"For these [remoteness inducing] measures to be valuable", the legal foundations on which they rest must be secure, and the resolution process can only start "when the borrowing bank still has enough residual assets that preferred or collateralized claims can be met. If, ex post, these conditions are not met, conflict may be intensified. Hence, bank stability might be enhanced by limiting total asset encumbrance (preferred deposits plus collateralized borrowing) to below the likely minimum level of residual assets. Authorities that are willing and able to take early corrective action, and therefore rarely have to deal with banks left with scant residual assets, can be more sanguine about asset encumbrance."

Note: the above implies that any DGS must price-in the call on assets that is senior to the collateralized call, since the timing of deposits is less tractable (due to demand deposits and short-term notice deposits) than the call on assets relating to collateralized claims. This is non-trivial, but not covered in the paper.

The conclusions of the study also "lead on to other questions [or conclusions] of practical relevance", include the following:

• "Why is information on bank asset encumbrance not more readily available? Appropriate pricing of both collateralized and non-collateralized borrowing depends on making good estimates of probability of failure and of loss given default facing different creditors, and thus of the degree of outstanding asset encumbrance. Yet it is difficult to obtain current or detailed, bank-by-bank information …typically one cannot know the volume of assets pledged in the interbank market, to the central bank, in liquidity swap and derivative deals, etc." 
• "What are the implications for funding behavior and stability of heterogeneity among creditors in their litigating/lobbying ability and incentives?"
• "In what ways would statutory bail-in of unsecured creditors be symmetric to the granting depositors preferred status, and in what ways would contingent capital (“CoCos”) be symmetric to collateralized credit?" 

Overall, the main conclusion of the paper is: "Depositor preference and collateralization of borrowing may reduce the cost of settling the conflicts among creditors that arises in case of resolution or bankruptcy. This net benefit, which may be capitalized into the value of the bank rather than affect creditors’ expected returns, should result in lower overall funding costs and thus a lower probability of distress despite increasing encumbrance of the bank’s balance sheet. The benefit is maximized when resolution is initiated early enough for preferred depositors to remain fully protected."