It makes sense to have special insolvency procedures for banks. Traditional court-led resolutions used by ordinary companies proceed too slowly. Banks are subject to losses of confidence that can infect the entire financial system. Taking action only when a bank is insolvent is too late. The FDIC, for example, can step in if a banks ratio of tangible equity to total assets drops below 2%. America has learned, however, that such considerations do not just apply to banks. When troubles emerged at Bear Stearns, Lehman Brothers and AIG last year, American authorities were hamstrung. Because none was technically a bank, the authorities could not intervene in the way they did with Colonial.
These flaws are being addressed. Bills sent to Congress late last month would allow the Treasury to appoint the FDIC or the Securities and Exchange Commission as receiver for any large financial holding company that posed a threat to financial stability, although regulators are squabbling over who would get to make the final decisions. For its part, Britain has had a new bank-resolution regime since February, one that the International Swaps and Derivatives Association considers state of the art. Now, when the Financial Services Authority, a regulator, judges a bank (or insurer) of any size to be dangerously close to insolvency, the Bank of England can seize control, bring it into public ownership or sell parts of it to other banks.
Winding up the biggest financial firms will still be hideously tricky, however. Private buyers are less likely to be able to swallow them whole, for one thing. Counterparty networks are more complex. In both Britain and America regulators are asking firms to produce death plans that lay out how they can be efficiently liquidated or dismembered under financial stress. The American Treasurys experiences with Bear Stearns and AIG showed that these firms would be almost impossible for a government administrator to carve up in a crisis without an instruction manual.
Illustration by S. KambayashiLarger firms tend to be international ones, too. Companies like Citigroup or HSBC operate with intricate corporate structures across different jurisdictions, yet it is not clear how they would be resolved across borders. America has long operated a nationalistic insolvency regime that ring-fences the domestic assets of banks that become insolvent, whether they are American or foreign, in order to compensate American deposit-holders. More effort should have gone into clarifying international insolvency, say some. Britain might introduce a new special resolution regime, but it wont work properly if that institution has branches in America, says Robert Bliss of Wake Forest University.
Larger financial firms also benefit from an implicit government guarantee that they will be bailed out if they get into trouble. In theory, resolution regimes could help instil greater market discipline by specifying ahead of time what would happen to shareholders and creditors in the event of a failure: mandatory haircuts, say, or compulsory debt-to-equity conversions. In practice, official proposals have not yet headed down this path. Having bailed out so much of the system this time round, promises not to do so again ring a touch hollow. And if they were seen as credible, pre-specified losses would hike the costs of bank financing.
As it is, creditors rights have arguably been weakened by the new and proposed resolution regimes. Because tottering banks in America and Britain can be seized before they are even insolvent, some reckon that shareholders property rights are at risk of being illegally infringed. Others worry that creditors of failing financial firms have no judicial recourse. In ordinary bankruptcy proceedings, the creditors do not get to make the decisions about how to wind up the afflicted firm, so why should the government when it becomes a creditor asks Mr Bliss.
The Economist Newspaper Limited