Bank Resolution and the Structure of Global Banks

Patrick Bolton is Barbara and David Zalaznick Professor of Business at Columbia Business School, and Martin Oehmke is Associate Professor of Finance at the London School of Economics and Political Science. This post is based on their recent paper.

Related research from the Program on Corporate Governance includes The Resolution of Distressed Financial Conglomerates by Howell E. Jackson and Stephanie Massman; and Containing Systemic Risk by Taxing Banks Properly by Mark J. Roe and Michael Troege.

How should prudential regulators deal with global banks that are too big to fail? Many see bank resolution as the key element in dealing with this challenge. The main idea is that global systemically important banks (G-SIBs) are required to issue a sufficient amount of “total loss absorbing capital” (TLAC) in the form of subordinated long-term debt or equity. These securities are issued for the purpose of absorbing losses and recapitalizing the institution in resolution, with minimal disruption to the bank’s operations and without public support.

But what should these resolution frameworks look like and, most importantly, will they work? Much hinges on this question, given that there are currently around thirty G-SIBs, with total exposures equal to more than 75% of global GDP in 2014.

In the paper Bank Resolution and the Structure of Global Banks, we provide a framework to assess the key trade-offs that arise in cross-border resolution of global banks. We argue that the main difficulty in designing effective resolution regimes for such G-SIBs is the mismatch between the global nature of these institutions and the national scope of the regulators charged with carrying out their resolution.

Because of this mismatch, it is imperative to take into account the political constraints and incentives of national regulators when designing resolution regimes. Drawing on a framework based on standard corporate finance and banking theory principles, we show that conducting a single resolution of the top holding company of the G-SIB (a single-point-of-entry or SPOE resolution) is efficient in principle (it economizes on TLAC and preserves the global bank as a whole), but that such a global resolution is not always compatible with the interests of national regulatory authorities. When this is the case, resolving a global bank along national lines (a multiple-point-of-entry or MPOE resolution) is generally the better option.

National interests are important both ex ante (i.e., when setting up a resolution regime) and ex post (i.e., when the resolution actually takes place). From an ex-ante perspective, the issue is that a global SPOE resolution usually involves expected transfers from one jurisdiction to another. The regulator in the jurisdiction that is more likely to make transfers may object to setting up a global SPOE resolution framework. Even though a global resolution would be efficient, national regulators that care more about outcomes in their own jurisdiction – for example, because of political economy considerations – prefer setting up a national resolution regime in order to limit transfers to other jurisdictions. Asymmetries across jurisdictions raise challenges in setting up a global SPOE resolution regime similar to those encountered by EU countries in setting up an EU-wide deposit insurance scheme.

The ex-post difficulties with a global SPOE resolution are perhaps even more serious. Here the issue is that national regulators may decide not to honor what they signed up for when the resolution is actually carried out. In particular, when the cross-jurisdictional transfer that is necessary to successfully carry out an SPOE resolution is too large, national regulators will prevent those transfers by ring-fencing assets in their own jurisdiction. Such a breakdown of a planned resolution is the worst of all outcomes, as it is likely to cause a financial panic similar to that following the collapse of Lehman Brothers in 2008. The possibility of an ex-post breakdown needs to be taken into account already when resolution regimes are designed. When it can be foreseen that a global SPOE resolution will not be incentive compatible ex post, then planning for and conducting separate resolutions in different jurisdictions via an MPOE resolution is preferable.

What determines which type of resolution is appropriate? Our analysis shows that whether a global SPOE resolution can be carried out successfully depends on the risk profile and the operational structure of the global bank in question. The bank’s risk profile matters because the size of the transfers required during resolution is a function of the correlation of the bank’s cash flows and asset values across jurisdictions. The bank’s operational structure matters because the incentives for national regulators to make the transfers required in conducting a global resolution depend on how costly it is for them to revert to a resolution along national lines and thereby break up the bank.

Overall, our analysis highlights that credible G-SIB resolution is not one-size-fits-all. Rather, resolution should take into account a bank’s risk structure and operational complementarities across different jurisdictions. A global SPOE resolution is more likely to succeed when there are large operational complementarities across jurisdictions that would be lost in case of a break-up through a national resolution. Moreover, we show that incentive compatibility can sometimes be restored by following a hybrid approach, where some of the bank’s TLAC is pre-assigned to a particular jurisdiction before the resolution takes place. Such pre-positioning reduces the need for ex-post transfers, thereby restoring incentive compatibility, but it comes at the expense of reducing the benefits of resource sharing in resolution.

In the final part of our paper, we investigate how the adopted resolution model (SPOE or MPOE) affects the incentives within the global bank. The key point here is that equity serves a dual role: Outside equity (or long-term debt) serves as TLAC, but inside equity is important for the incentives of bank managers. Our model shows that a global SPOE resolution affects incentives for the global bank’s operating subsidiaries in two ways. Relative to MPOE, SPOE dampens the incentives because cash flows generated in one jurisdiction are sometimes transferred to plug a hole in the other jurisdiction. But since SPOE economizes on loss-absorbing capital, SPOE resolution can allow the bank to retain a larger inside equity stake, which allows the bank to provide stronger incentives to affiliate managers. The second, positive effect dominates when the diversification benefits from a global SPOE resolution are sufficiently large.

The complete paper is available for download here.

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