Some bank mechanisms can help reduce idiosyncratic, but not necessarily systemic, risk, write Aneta Hryckiewicz, Natalia Kryg and Dimitrios P. Tsomoco

Hryckiewicz, Aneta

Kryg, Natalia

English

LSE Research Online

Bank	resolution	mechanisms:	how	to	prepare	for	abirthday	with	an	imperfect	planThe	regulatory	changes	introduced	after	the	2007-08	global	financial	crisis	require	banks	to	have	contingency	plansin	case	of	distress.	However,	it	is	still	not	clear	how	such	plans	could	be	effective	in	resolving	banks’	problems	andmitigating	systemic	risk.	The	COVID-19	crisis	and	the	drastic	policy	response	that	followed	has	produced	an	armyof	companies	limping	along	in	the	twilight	between	the	living	and	the	dead.	Many	firms	face	cash	flow	and/orsolvency	difficulties	at	a	scale	unseen	before.	There	are	rising	concerns	regarding	rapidly	accumulating	amounts	ofnon-performing	loans	(NPLs)	on	banks’	balance	sheets.	Banks	are	under	pressure	to	submit	a	contingencyproposition	to	regulators	in	which	they	propose	their	recovery	plan.	Unfortunately,	they	need	to	prepare	for	such	a‘birthday’	with	an	imperfect	plan.Despite	significant	progress	already	made	in	formulating	bank	resolution	objectives,	many	concerns	remain	as	towhether	the	new	mechanisms	will	work	effectively	during	the	“next”	financial	distress	episodes.	More	importantly,	itis	not	clear	how	they	operate	in	the	event	of	a	crisis	of	a	systemic	nature.	Although	bank	bailouts	are	seen	as	“deadtools”	due	to	their	moral	hazard	incentives	as	well	as	high	budgetary	costs,	many	scholars	argue	that	early	andtimely	government	intervention	was	extremely	important	for	limiting	both	the	contagious	effects	of	a	crisis	and	itssubsequent	repercussions	(e.g.,	Berger	et	al.,	2020).	Moreover,	government	has	also	played	an	important	role	instimulating	bank	lending	or	NPLs	restructuring	(e.g.,	Berger	and	Roman,	2015;	Homar,	2016).	Thus,	policymakersand	regulators	wonder	whether	bank	bail-ins	and	redirecting	bank	resolution	to	bank	managers	and	other	creditorswill	indeed	be	more	effective	than	the	use	of	bailouts	and	under	what	circumstances.The	requisite	scepticism	centres	around	four	key	issues.	First,	redirecting	banks’	problematic	asset	to	the	privateinvestors	might	be	difficult	given	high	market	uncertainty,	limited	market	liquidity,	and	inconsistencies	in	assetvaluation,	which	generally	accompany	financial	crises,	not	to	mention	the	adverse	systemic	events	when	equitymarkets	are	extremely	thin.	Second,	the	resolution	of	NPLs,	especially	when	the	losses	are	redirected	to	thecreditors	and	the	management	generates	moral	hazard	issues	with	respect	to	incentives	to	conduct	effectiveresolution	(particularly	in	the	absence	of	any	associated	penalties)	might	lead	to	managerial	forbearance,	and	thusdelay	banks’	recovery.	Third,	the	amount	of	support	offered	by	the	creditors	by	redirecting	the	losses	might	beinadequate	as	contrasted	to	the	typical	bailout	mechanism.	Consequently,	we	might	expect	a	slower	recovery	andlimited	credit	extension	from	the	banking	sector.	Finally,	given	the	aforementioned	reservations	it	is	questionable	toassume	that	available	new	resolution	mechanisms	will	have	a	material	effect	on	systemic	risk	mitigation.LSE Business Review: Bank resolution mechanisms: how to prepare for a birthday with an imperfect plan Page 1 of 3		Date originally posted: 2020-11-05Permalink: https://blogs.lse.ac.uk/businessreview/2020/11/05/bank-resolution-mechanisms-how-to-prepare-for-a-birthday-with-an-imperfect-plan/Blog homepage: https://blogs.lse.ac.uk/businessreview/In	our	new	paper,	we	analyse	the	effectiveness	of	selected	resolution	mechanisms	with	respect	to	the	bankingsector	recovery	and	its	systemic	risk	implications.	We	use	a	novel	dataset	of	banks,	which	has	been	subject	toresolution	mechanisms	during	episodes	of	systemic	events	and	compare	them	to	those	that	were	not	under	anyresolution.	We	compare	our	results	with	financial	institutions	that	were	bailed	out	during	the	same	period.	Oursample	covers	39	systemic	banking	crises	during	the	period	of	1992-2017.	Figure	1	summarises	our	results	on	thespectrum	of	the	success	likelihood	(i.e.,	measurers	of	bank	financial	performance)	of	the	studied	resolutionmechanisms	(y-axis)	and	the	severity	of	the	crisis	during	which	these	interventions	occurred	(x-axis).Figure	1.	The	trade-offs	between	the	success	of	bank	resolution	mechanisms	and	the	degree	of	crisis	severitySource:	Authors	(2020)LSE Business Review: Bank resolution mechanisms: how to prepare for a birthday with an imperfect plan Page 2 of 3		Date originally posted: 2020-11-05Permalink: https://blogs.lse.ac.uk/businessreview/2020/11/05/bank-resolution-mechanisms-how-to-prepare-for-a-birthday-with-an-imperfect-plan/Blog homepage: https://blogs.lse.ac.uk/businessreview/Our	results	suggest	that	current	bank	resolution	mechanisms	can	be	effective	in	addressing	only	idiosyncraticrisk.	However,	in	case	of	severe	crises	they	should	be	accompanied	by	sufficient	recapitalisation.	We	argue	that“one-policy	fits	all”	does	not	hold.	More	specifically,	we	notice	that	in	the	early	stages	of	the	crisis,	mergers	areeffective	in	resolving	distressed	banks	without	any	additional	financial	support.	However,	in	the	event	of	a	severefinancial	crisis,	the	creation	of	a	“bad	bank”	needs	to	be	accompanied	by	sufficient	recapitalisation.	Only	then	do	wenotice	an	improvement	in	bank	performance	as	well	as	a	formidable	restoration	of	bank	activity.	We	argue	that	purerestructuring	under	a	“bad-bank”	mechanism	is	not	sufficient	to	restore	bank’s	health	(i.e.,	advanced	stage/lowsuccess	spectrum	in	Figure	1).	The	lack	of	sufficient	capital	discourages	banks	from	undertaking	substantiverestructuring	and	declaring	their	actual	losses,	possibly	due	to	negative	market	reactions.	At	the	same	time	purerecapitalisation	without	any	restructuring	procedures	does	not	help	either.	More	importantly,	we	claim	that	bailoutsdo	not	seem	to	address	either	systemic	or	banks’	idiosyncratic	risks	in	an	efficient	way.	Our	results	stronglyencourage	policymakers	to	speed	up	their	work	on	resolution	mechanisms	that	aim	at	mitigating	systemic	risk.♣♣♣Notes:This	blog	post	is	based	on	the	authors’	2020	working	paper	“New	bank	resolution	mechanisms:	Is	it	the	end	ofthe	bailout	era?”.The	post	expresses	the	views	of	its	authors,	not	the	position	of	LSE	Business	Review,	the	London	School	ofEconomics	or	EBRD.Featured	image	by	Christian	Wiediger	on	UnsplashWhen	you	leave	a	comment,	you’re	agreeing	to	our	Comment	PolicyAneta	Hryckiewicz	is	a	professor	at	Kozminski	University	in	Warsaw.			Natalia	Kryg	is	a	senior	associate	at	the	European	Bank	for	Reconstruction	and	Development(EBRD)	in	London.		Dimitrios	P.	Tsomocos	is	a	professor	of	Financial	Economics	and	fellow	in	Management	at	SaïdBusiness	School	and	St.	Edmund	Hall,	University	of	Oxford.		LSE Business Review: Bank resolution mechanisms: how to prepare for a birthday with an imperfect plan Page 3 of 3		Date originally posted: 2020-11-05Permalink: https://blogs.lse.ac.uk/businessreview/2020/11/05/bank-resolution-mechanisms-how-to-prepare-for-a-birthday-with-an-imperfect-plan/Blog homepage: https://blogs.lse.ac.uk/businessreview/

Bank resolution mechanisms: how to prepare for a birthday with an imperfect plan

http://eprints.lse.ac.uk/107661/1/businessreview_2020_11_05_bank_resolution_mechanisms_how_to_prepare.pdf

Bank resolution mechanisms: how to prepare for a birthday with an imperfect plan

Abstract

Similar works

Full text

Available Versions

LSE Research Online