BankThink

How not to clean up a bank failure

During and since the financial crisis, the challenge of how to address the potential failure of major banks has been a significant focus of policymakers in the United States and Europe. In the last decade, both jurisdictions have enacted sweeping reforms to create safeguards that shield taxpayers from bearing the cost of government bailouts that could be justified as necessary to prevent systemic contagion.

In the U.S., the largest financial institutions have been required to draft “living wills” that provide a blueprint for their hypothetical restructuring, and to submit to periodic stress tests that confirm their ability to withstand severe economic conditions. But the absence of any major bank failure since the Great Recession has left untested the “orderly liquidation authority” granted to the federal government in 2010 under Title II of the Dodd-Frank Act.

Recent events in Europe, however, may serve as a harbinger of how these powers could cause problems in the U.S., highlighting the potential need for a better path forward: modified reorganization protection for financial institutions under Chapter 11 of the U.S. Bankruptcy Code.

European Central Bank
A euro currency symbol sits on a eurosystem sign outside the the European Central Bank (ECB) headquarters in Frankfurt, Germany, on Thursday, April 27, 2017. The ECB kept interest rates unchanged at record lows and maintained its quantitative-easing program as officials monitor the economic recovery and the risk of political turbulence in the region. Photographer: Alex Kraus/Bloomberg

On June 6, the Madrid-based Banco Popular Español S.A. was declared by the European Central Bank to be “failing or likely to fail.” The Single Resolution Board (SRB), the European Union body created in 2015 to ensure the orderly wind-down of troubled financial institutions, orchestrated overnight the sale of Banco Popular Español to Banco Santander, Spain’s biggest bank, for the symbolic sum of €1 ($1.10).

The regulators (and headlines) heralded the transaction as a huge success. According to Elke König, chair of the SRB, the deal showed “that the tools given to resolution authorities after the crisis are effective to protect taxpayers’ money from bailing out banks.”

From that narrow perspective, König is correct. Instead of the government bailouts that epitomized the global financial crisis, Banco Popular Español's failure was not resolved with taxpayer funds, but rather through a series of measures that included a “bail-in” of about €2 billion ($2.3 billion) of the failed bank's securities, including contingent convertible bonds and equity. (Contingent convertible bonds, also referred to as CoCos, are debt instruments that can automatically be exchanged into equity upon the occurrence of an insolvency trigger.)

As the dust is still settling, Spanish taxpayers may be in the clear, but the ECB, Banco Popular Español and Santander — as well as their shareholders and creditors — are just beginning to fight. This is due primarily to flaws in these new administrative resolution processes, namely the lack of transparency, established precedent and a forum in which to enforce creditor rights.

Shareholders and unsecured bondholders of Banco Popular Español appear to have had no insight into the process, or any right to be heard, until after it was over. Disputes over the valuation of the bank, the need for the sale and the manner in which it was handled, are already surfacing. Certain investor groups have already commenced litigation seeking to annul the transaction and reverse the decision of the ECB.

Santander has launched a €1 billion program to compensate Banco Popular Español's retail investors, who had lost money with up to € 980 million of “loyalty bonds.” In exchange, “customers will be required to waive the right to pursue legal actions against Santander, its directors, managers and employees.”

These issues are similar to concerns that have been raised in the U.S. with respect to Dodd-Frank’s Title II and its orderly liquidation authority, in terms of how a large failure would be handled here. Based on how that authority is structured, these are unavoidable problems.

The Financial Institution Bankruptcy Act (FIBA) has passed the U.S. House of Representatives four times, without any dissent, and creates a bankruptcy alternative to Title II without replacing the Dodd-Frank framework. Put simply, FIBA would allow a failing bank to file for Chapter 11 and nearly immediately transfer its good assets to a newly formed bridge company that is not in bankruptcy. The bridge company would be capitalized by leaving behind unsecured debt. Creditors would pursue their claims against the debtor in the Chapter 11 case, and receive any distributable value from the liquidation of the bad assets and the equity in the bridge company.

Instead of an opaque process run by a federal agency that can render critical judgments, without meaningful explanation or a venue to resolve disputes, FIBA provides access to the U.S. Bankruptcy Court, where parties, including those who would bear the brunt of the “bail-in,” can pursue their claims before an experienced federal judge, consistent with conventional (and predictable) corporate reorganization practice.

While a resolution case under FIBA would get underway at the same speed as a Title II proceeding to ensure quick stabilization, every decision about the bankruptcy filing, asset transfer and value distribution would be subject to Bankruptcy Court approval and require the debtor to submit substantial amounts of evidentiary support. This burden ensures that the bank’s actions, including the impairment of creditors’ claims, are not taken lightly and are given deservedly adequate scrutiny.

Ideally, the Senate and President Trump will take the final steps to enact FIBA, so the U.S. banking system — and depositors and investors especially — can avoid the uncertainty and value-destructive tumult presently on display with Europe’s first big post-crisis resolution.

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