How can crisis-hit financial institutions be successfully reorganised or restructured?

The global financial crisis and particularly the failure of Lehman Brothers in the US, as well as the action taken to rescue Hypo Real Estate in Germany, have shown that the tools available for dealing with banks which get into trouble and which pose a threat to the stability of the financial system due to their level of interconnectedness in the marketplace are inadequate. At national level, financial institutions in Germany can now strengthen their equity levels and bridge liquidity squeezes thanks to state guarantees provided by the government-run Financial Market Stabilisation Agency SoFFin to facilitate refinancing. Yet this is no substitute for mechanisms to reorganise, restructure or, if necessary, wind down institutions which – once they are in distress – threaten to pose a systemic risk because they are seen to be “too big to fail”, though they are actually, first and foremost, “too connected to fail”.

Many initiatives
Numerous proposals for solutions have been tabled in the meantime and are being discussed both nationally and internationally. The International Monetary Fund (IMF), the Financial Stability Board (FSB), the Basel Committee on Banking Supervision and the European Commission are all dealing with the issue. But there has been more than just talk: the “EU Framework for Cross-Border Crisis Management in the Banking Sector” currently advocated by the European Commission will change supervisory practice for banks domiciled in the European Union.

In Germany, two bills on bank resolution were presented in 2009: one by the Economics Ministry in March and one by the Justice Ministry in August. Because of the national election campaign, both bills were temporarily shelved, however. The government now intends, as  set out in the Coalition Agreement, to launch legislation in the course of the current parliamentary term and has since resumed work in this direction that is being coordinated jointly by the Finance Ministry and Justice Ministry.

International framework needed
Is it a good thing that so many people are trying to come up with solutions? Yes and no. Yes, because competition for the best ideas may be helpful in solving this extremely important and complex problem. No, because there is the danger that the debate will become fragmented, making the broad international agreement on bank resolution arrangements that is actually required less likely. Yet international cooperation is necessary for two reasons: for one thing, because a distortion of competition is to be expected if countries go it alone and, for another, because – as we have learned from bitter experience during the financial crisis – national support measures or even rescue packages quickly reach their limits if an internationally operating institution needs help. But this may well be the rule if something happens. Then there is no alternative to cross-border crisis management by different national authorities.

Crisis management: coordinated, compatible, early
International cooperation does not mean, however, that all those involved have to submit to a completely identical supranational rulebook. But it does mean that any action they take must be coordinated and the tools they use must be compatible. The work done by national authorities certainly needs to interlock better than it has done to date.

The task in hand is responding earlier and more effectively to financial distress at systemically important institutions. The underlying aim is twofold: safeguarding the stability of the financial system and minimising the risk of recourse to public aid. In other words, the quicker systemic risk is identified and the more effectively it is controlled, the less harm is done to the financial system and the greater are the chances of not having to use the taxpayer’s money.

So how do the solutions currently proposed stand up against this objective? Unfortunately, there is a potential flaw as the legal framework contemplated by the European Commission is geared one-sidedly at present to large, internationally operating banks. Such an approach is too limited, however, as systemic risk would not be controlled either effectively or adequately in this way. The size of an institution is, by itself, no meaningful indicator of how likely the institution is to cause systemic risk. Neither Lehman Brothers nor Northern Rock, neither nor HRE nor IKB were particularly big banks, but they were highly interconnected and therefore a source of systemic risk.

One rulebook for all institutions
A look at not only the current crisis but also at a number of previous financial crises shows that nobody can say for certain which institution, market or financial instrument may pose a potential threat to financial market stability. The tools used in a crisis therefore have to be applicable also to, for example, groups of smaller institutions or highly interconnected institutions. The US savings and loan crisis in the 1980s and 1990s illustrates this.

Whatever rules are set or whatever tools are used to prevent systemic risk, they must cover all banks that may cause systemic risk. Anything else would distort competition between all potential systemically important institutions: it would be like imposing a requirement for only large vehicles to have additional liability insurance to cover damage suffered in mass pile-ups on motorways although small cars can obviously also cause such serious accidents as well.

So what requirements do the tools used to stabilise banks have to satisfy? For one thing, they must allow early intervention as soon as a crisis looms. This means that banking supervisory law should lay down clear-cut conditions which apply at an early stage and enable supervisors to enter into a dialogue with the bank on resolution arrangements. These conditions, which should at the same time be flexible, i.e. tailored to individual banks, need to be defined uniformly throughout the EU to ensure that different supervisory authorities take coordinated action where a cross-border institution is involved.

Personal responsibility before intervention
Shouldn’t a bank facing financial distress hand over control straight away to others? This does not necessarily make sense. What is better is a two-stage approach to reorganise, restructure or, where necessary, wind down such an institution. An ailing bank should be given a legal framework within which it can carry out resolution at an early stage, on its own and in an orderly manner. Only if its problems cannot be solved in this way should supervisors then step in. Resolution of other ailing enterprises has proved successful particularly whenever it was initiated by the enterprise itself and implemented quickly in agreement with the largest creditors.

A “public” administrative procedure under existing German law – whether in the form of  restructuring administration or insolvency proceedings – takes place relatively late in any case. National resolution mechanisms should therefore only come into play if financial difficulties cannot be overcome by the stakeholders – i.e. the bank, its owners and creditors – themselves.

Where there’s a fire, someone has to be able to put it out
The principles that need to be taken into account when an institution is reorganised or restructured are not completely conflict-free. On the one hand, for example, the rule is that the shareholders of an ailing institution always have to be involved in the proceedings. On the other hand, the financial crisis has shown that the measures needed to stabilise a bank often could not be implemented with the required urgency because company law leaves the decision on this to shareholders.

But recapitalisation, where it is deemed necessary, has to be carried out quickly in a crisis. The involvement of the shareholders’ general meeting in corporate actions should not be allowed to thwart the aim of stabilisation. If a house is on fire, the fire brigade must be able to put out the fire without having to obtain the agreement of the owners beforehand.

What, then, should be done? One way to resolve the conflict between owners’ sovereignty and time pressure is to amend the EU Company Law Directive: it should in future allow  banking supervisors instead of the shareholders’ general meeting to decide on action whenever the stability of the financial system is seriously jeopardised.

Enlarging the tool box: “bridge bank” and “good bank”
But there are other ways of reorganising banks efficiently – ways which the European Commission, too, recognises as generally appropriate: firstly, authorising transfer of an institution’s business activities to a private buyer or a temporary “bridge bank” in order to maintain the institution as a going concern; secondly, splitting the institution into a “good bank” and a “bad bank”; and, thirdly, appointing a receiver to restructure the ailing institution.

The “good bank” solution, i.e. spinning off systemically important parts of an institution quickly and easily for resolution purposes, is particularly attractive. Under this approach, an institution’s viable business units and systemically important business functions can be shielded effectively from the consequences of insolvency. The sound part of the bank can continue to operate by being sold to another institution or, if there is no private buyer, transferred temporarily to a public vehicle, a so-called “bridge bank”. This serves to minimise the systemic consequences of insolvency. The “bad” part of the institution would then have to be wound up under orderly insolvency proceedings with as little impact as possible on the market.

Sparing the market, not owners
At the same time, it is important that an institution’s owners should meet the losses accrued in full, while creditors, too, should be required to bear their share if possible – the aim is sparing the market, not owners. There is no other way the principle of liability and the principle of functioning competition, both cornerstones of the “social market economy”, can be reconciled.

International cooperation to prevent any distortion of competition
Drafting a rulebook for the resolution of financially distressed banks is an ambitious and urgent project. Ambitious because developing a set of tools for dealing with problem cases which are complex both economically and legally per se requires, in addition, internationally coordinated or, at the very least, compatible action. And urgent because the financial crisis has made us painfully aware of how quickly a supposedly small fire can turn into a destructive conflagration. Giving this project political shape and then putting it into legally binding form therefore still requires plenty of discussion.

Many ideas will have to be reviewed in the process. At present, a “living wills” pilot programme is underway in the UK. Whether ready-made plans for winding down an institution are actually sensible and practical remains to be seen. There are even calls for banks to be structured according to the “lego principle”, i.e. so that they can, in particular, be broken up more easily in a crisis, rather than in a way that allows them to operate successfully. But that would definitely mean throwing out the baby with the bath water.

However difficult the task of creating a robust bank resolution framework may be, it must be accomplished. The aim of all those involved must be to draft a rulebook that prevents systemic crises as far as possible and proves practical at the same time.

Convergence between the different national tools is important not only so that the tools work whenever resolution of cross-border banks is required. It is also important so as to avoid any distortion of competition, since competition is essential to market efficiency. This, in turn, makes clear the fundamental challenge that has to be met: we need stable and efficient financial markets, as well as stable and efficient banks. The G20, the Basel Committee on Banking Supervision, the European Commission and all the rest of us would be well advised never to lose sight of this target.