September 18, 2014 - The following op-ed by IIF President and CEO Tim Adams appeared in the Thursday, September 18 edition of the Australian Financial Review (subscription required)
Ending "too big to fail"-and the resulting taxpayer bail-out as in the crisis-has headed the G20 financial agenda since 2009. Recently, Mark Carney, governor of the Bank of England and chairman of the Financial Stability Board, stated that 2014 was the year to "complete the job". We agree and support this critical reform of banking industries around the world.
Shareholders and creditors, not taxpayers, should bear the cost of bank failures. Banks' critical economic functions, such as credit formation and making payments, have to continue while a bank is being "resolved", much the way that airlines continue to fly even while in bankruptcy reorganization. Taxpayers and the wider economy must and can be protected in case of resolution of an international bank.
The root of the "too big to fail" problem is well known. Industrial corporations can enter insolvency proceedings without closing factories, laying off workers and disrupting the economy. But during the crisis, banks could not be allowed to fail because regulators and the financial community had no mechanism to restructure banks without bringing credit formation, deposit-taking, payment and risk management functions to a halt.
The FSB Key Attributes of Effective Resolution Regimes for Financial Institutions set out a global model for the solution to this problem in 2011. Most jurisdictions that house international banks now have resolution regimes that conform to the Key Attributes. The FSB has achieved a paradigm shift in thinking about failures of banks, including bail-in and other tools for different circumstances. Although applying it to the detail of global bank operations is challenging, extensive public and private sector work has brought us within reach of the goal.
It has become clear that one of the important resources for stabilization in resolution will often be liabilities that can be written down or converted to common equity at the point of non-viability-in other words, "loss-absorbing capacity" that can be "bailed in", whether directly or via a bridge institution under the Dodd-Frank Orderly Liquidation Authority in the US.
Bail-in enables the resolution authority to have investors absorb losses and as necessary recapitalize the bank, usually after replacing management and eliminating (or severely diluting_ preexisting equity. Restoration of adequate capital, using bail-in and other resources appropriate to the bank's business model, should enable the bank to obtain liquidity, so it can retain access to financial markets and avoid close-out of financial contracts. As a result, it can perform critical economic functions, minimizing disruption to financial markets and the real economy during a restructuring, analogous to an industrial reorganization. This would, in all foreseeable cases, also preserve more value for creditors than liquidation at the point of crisis.
People sometimes wonder if the reform effort will truly make a difference. Let's look at the progress on this issue. In 2008, there was no plan for what to do if a big bank failed. Today, we have agreed international principles. Legislatures have put these principles into law in countries where global banks are most active. The FSB is expected this northern autumn to make proposals to establish clear criteria for the "loss-absorbing capacity" banks should have to carry out a resolution.
Some worry that execution will be challenging the first time there's a resolution under the Key Attributes. Indeed, naysayers are pronouncing it doomed to failure. That is to be expected-if they identify real problems and help find solutions, they too are part of the answer.
In fact, we have gone from "no idea" to new laws, clear financial means, and detailed plans in a very short period. As a result, as the US Treasury has recently pointed out, there's already a sound basis for successful action.
The critical fact is, investors in bank debt are already pricing in the possibility of bail-in. Despite theorizing to the contrary, the credibility of the resolution regime is already being established. More transparency by the authorities and dialogue on multilateral action would help, a need the FSB's planning recognizes.
Banks need to continue improving disclosure. But the market sees the direction of travel. This will help discipline bank behavior over the long term.
We now have the tools to handle a failed bank-without cost to taxpayers and with protections to ensure that activities critical to the real economy continue.
Sound principles to prevent value destruction create incentives for authorities to co-operate across borders. Banks should be subject to failure-not bail-out-in a market economy, the same as other businesses.