Climbing out vs. pushing under: the ‘everyone step down a notch’ theory of bank resolution May 14, 2011 at 10:35 am

I could be wrong. I had thought that the idea of bank bail ins was to dilute or extinguish ordinary shareholders, to turn bail-in (tier 2 or coco) instruments into new equity, but to preserve senior debt holders. It seems that the last bit is not necessarily true. It is being contemplated, I understand, that bank resolution regimes may also convert some portion of the senior into equity. That’s going to make selling all that long-dated senior debt that the Basel III liquidity requirements demand quite difficult. Perhaps if you took your foot off my head, I might be able to climb out of the water…

Take your foot off my head

What should we do instead? Well, the priority order of securities gives a strong clue. If a bank is in resolution, it by definition it cannot carry on. Therefore shareholders, as bottom of the priority order, should be wiped out. The new equity in turn comes from the sub debt holders; the conversion of their instruments gives us the vast majority of the new equity as we are massively diluting the equity holders. Logically then senior debt holders should step down too, with some of their notional being converted into new sub debt.

Now for a really delicate question: what do you do about covered bonds? Well, a covered bond is a claim which first has assets supporting it and second is senior. Following the logic above, the covereds keep their assets, but a part of their claim should become subordinated. Now I full admit that it is likely that this particular policy choice will be ignored, but it is the logical consequence of the ‘everyone steps down a notch’ theory of bank resolution.

Update. An FT alphaville post on the Swedish bail-in/out/shake it all about regime made me think that it is worth clarifying how much you need to do at each step in the ladder. The first decision is whether to bail in or just let the institution go into bankruptcy. Then if you bail in, you first decide how much equity you need. You compare that with how much you have, based on an independent valuation, with how much you need. Convert enough Cocos to get you there. Then compare the remaining Coco stock, if any, with how much you need, and convert enough senior debt into Cocos to get you there too.

2 Responses to “Climbing out vs. pushing under: the ‘everyone step down a notch’ theory of bank resolution”

  1. […] my earlier post on bank resolution, I tried to discuss bail in in a way that respected priority. There’s no […]

  2. […] convert investors’ holdings of the bank’s debt into its equity — then it will be really difficult to get the point of converting senior debt into equity. It’s right there at the top of the […]