A Recovery Procedure for Undercapitalized Banks

The rapid escalation in uninsured deposit runs in March 2023 led to chaotic intervention with potentially severe fiscal implications. The runs spotlighted once again the limit on prudential norms. Since the collapse of SVB, Credit Suisse, and other smaller banks in 2023, many reform proposals have focused on stronger ex-ante prudential measures, such as higher capital and liquidity rules. Yet other proposals have included an expansion of public insurance for corporate deposits. In our view, higher capital and liquidity rules would be most effective but also controversial because of their cost, while expanding insurance would also be costly and lead to more risk.

In a recent paper, we propose an alternative that focuses on the role of the supervisor (Pillar II) in prompting recovery of solvent yet undercapitalized banks though the timely activation of interim measures. Our aim is to restore credibility to timely intervention and empower the supervisory authority to prompt the recovery of viable banks.

Contingent Measures: Favouring Recovery Over Resolution

The 2023 experience showed how supervisors failed to take timely and concrete steps to help viable banks slipped towards insolvency because the supervisors worried about triggering uncontainable runs. Such regulatory forbearance buys time but leads to a steady deterioration of value and increased losses. Thus, the current regulatory framework has a major blind spot: Once a bank becomes undercapitalized, there are no credible tools to promote recovery or contain runs.

Figure 1

Without intervention, supervisors are left with two sub-optimal options. Current preventive tools at prevention like suspending dividend payments offer little immediate relief while sending a signal about bank losses, thus triggering a run. This gives rise to a ‘capital forbearance’ game, where a lack of credible measures leads shareholders and regulators to gamble on a recovery. Prolonged forbearance worsens capital deterioration, leading to rising fiscal losses (Figure 1).

We propose two preventive measures to fill the intervention gap. The first, on the capital side, would be strengthening the Pillar II mandate on the going concern loss-absorption of contingent convertible debt. The second, on the liquidity side, is to introduce redemption charge upon large outflows. These proposals would be credible only in combination with tools to contain any escalation of outflows. Redemption fees similar to the new rules the SEC recently adopted for prime money-market funds would be directly triggered by high daily outflows of uninsured deposits so as to act as automatic stabilizers. This is in line with market practices as money-market funds have long been the main destination for corporate cash, offering reliable liquidity and a better yield with modest price risk.

Redemption charges would eliminate the incentive to respond to outflows with withdrawals, thus directly reducing run incentives. Charges imposed quickly would also reduce expectations for further withdrawals by others, avoiding escalation driven by fear of dilution rather than solvency concerns or liquidity needs. Charges may be seen as a Pigouvian tax on withdrawals with no liquidity needs and would force withdrawing depositors to internalize the liquidity externality they cause.

Figure 2 depicts the key nodes for a solvent but undercapitalized bank when both capital and liquidity recovery measures are in place.

Figure 2

Recovery Procedure: Goals and Principles

To ensure effective recovery, we propose to design a formal procedure, to avoid the forbearance trap described above. Such a procedure represents the functional equivalence of privately led recovery processes for non-financial firms in debt overhang. Given the special nature of banks, specifically the short-term nature of their liability and the systemic externalities associated with their distress, private actors have no incentives to coordinate towards early recovery. Nonetheless, coordination is socially desirable so that supervisory powers should mimic the outcome of private workouts, should these have been possible. Table 1 summarizes the functional equivalence between distress procedures for non-financial corporations and banks, highlighting how an effective recovery procedure represents the missing piece of the puzzle.

Table 1

Having defined the rationale for interim intervention and having identified the key measures to maximize the probability of recovery, two key challenges remain open: legitimacy and calibration.

Legitimacy is not only crucial for upholding the rule of banking law but also has ramifications for strategic interactions between the supervisor and the banks it oversees. The supervisor will be willing to use intrusive powers only as long as they do not create disproportionate legal risks for the agency.

The calibration of the various interim measures is the other key challenge. A full-fledged calibration exercise would require a formal mode; however, some basic calibration principles can be derived from theory and current practices. Table 2 displays the principles guiding the calibration of interim measures.

Table 2

More work is needed to design an effective recovery procedure for solvent but undercapitalized banks. However, based on our analysis, some principles emerge as guidelines for future research and policymaking:

1. Legitimate activation. There is not a single reliable indicator for early bank distress. Therefore, the activation of the recovery procedure should rely on a variety of relevant indicators, such as market and book value of equity, auditor and supervisory evaluations, stress-tests outcomes, and large outflows.
2. Short-term mandate. The enhanced powers should be available to the supervisor for a short time window to ensure proportionality and limit supervisory legal risk.
3. Complementarity of capital and liquidity measures. The recovery measures should ensure prompt deleverage through the conversion of CoCos and, at the same time, have in place redemption charges to contain potential runs.
4. Powers to reshape on impact on the risk profile and the business model. These additional powers are crucial to ensure a genuine recovery. Many of these powers are already included in the supervisory toolkit but remain largely ineffective because of the forbearance incentives.

This post is based on the authors’ full article available here.

Enrico C. Perotti is a Professor of International Finance at the University of Amsterdam and Research Fellow at the Centre for Economic Policy Research (CEPR).

Edoardo D. Martino is an Assistant Professor of Law and Economics at the University of Amsterdam and a Research Associate at the European Banking Institute.