“A British bank is run with precision
A British home requires nothing less
Tradition, discipline and rules
Must be the tools
Without them: disorder, catastrophe, anarchy
In short, you have a ghastly mess!”
George Banks and chorus in ‘Mary Poppins’
Mary Poppins, as every adult knows, is about banking not childcare.
For financial aficionados the Mary Poppins dramatic force hinges around the run on the fictional Fidelity Fiduciary Bank (officially, the ‘Dawes, Tomes, Mousely, Grubbs Fidelity Fiduciary Bank’) rather than house-keeping issues.
Apologies for the spoiler but the Fidelity Fiduciary Bank capital buffers prove inadequate against the loss of customer confidence sparked by a single child demanding the return of his coins.
At the time of its release in 1964 and for decades to follow, the Mary Poppins bank run would have appeared a more fanciful plot device than accurate depiction of real life – in Britain at least. But in 2007 the Fidelity Fiduciary mayhem depicted in the Academy Award-winning movie was mirrored in reality as customers queued on UK streets to close accounts at the failing Northern Rock bank.
Northern Rock was eventually bailed-out but the spectre of bank failure, brought into sharp focus across the world at the height of the global financial crisis (GFC), triggered huge taxpayer-funded banking rescue missions in many jurisdictions.
As explored in previous Fiorinos, post-crisis governments globally determined to ward off future bailouts with a series of measures designed to shore-up bank capital adequacy and set new procedures for managing financial institutional failures in a manner that more fairly apportioned risk.
Regulators dusted-off the antiquated notion of ‘resolution’ to describe the new method for tackling bank runs.
Resolution regimes set the procedure for failing banks to be sold or close without disrupting the wider financial system or leaving taxpayers on the hook. As well, the bank resolution rules respect the hierarchy of liquidation claims by allowing shareholders and unsecured and uninsured creditors to absorb losses as per well-defined protocols.
In the aftermath of the GFC, investors, as well as regulators, have been forced to take into account the real prospect of bank failures when assessing risks. The so-called ‘Doomsday Argument’ (DA), first laid out in formal statistical language by astrophysicist Brandon Carter in 1983, offers another gloomy view on the odds of future bank runs.
Essentially, Carter suggested it was possible to predict the number of humans who will ever live by estimating the number of people who have ever been alive to date. According to some versions of the DA postulate, given the human race has produced about 100 billion individuals to date, probability theory suggests the species is about midway through its run, leaving us a miserly 1,000 years or so of existence.
Of course, the DA methodology does not apply exactly to assessing the risk of bank failures. However, the Carter theory does invite analysts to consider future bank runs as possible events instead of impossibilities.
US v Europe: resolving the differences
In the US the Dodd-Frank Act (DFA) is the key legislative instrument governing the country’s banking system. The DFA is split between Title 1 (oversight of large financial institutions) and Title 2 (resolution powers).
Banks in Europe, however, fall under different measures covered in state aid rules and the Bank Recovery and Resolution Directive (BRRD)1. The BRRD provides an overarching framework to ensure troubled financial firms can be repaired or resolved without public money.
Both DFA and BRRD share a common emphasis on financial stability along with setting similar conditions for opening resolution proceedings and defining administrative powers. Nonetheless, there are important differences between the two regimes, notably the lack of a restructuring option in the US or the latitude surrounding precautionary recapitalisation measure in the EU.
The DFA specifies three cumulative conditions for starting a resolution:
- the restructuring of the failing firm through contractual arrangements is not possible;
- the application of corporate insolvency law would lead to economic inefficiencies; and,
- the bankruptcy of the financial institution could endanger financial stability.
Ranking first, ‘contractual arrangements’ refers to resolving or restructuring a bank via the private sector. Instruments such as contingent convertible bonds – or ‘CoCo’ – can offer a private sector exit route for troubled banks by transforming debt into equity.
FDIC, a key player in the US
Established in 1933, the Federal Deposit Insurance Corporation (FDIC) is an independent agency of the US government that protects bank deposits. FDIC insurance is backed by the full faith and credit of the US government. To date, no depositor has lost a penny of FDIC-insured funds.
Importantly, the DFA gives the FDIC broad discretionary power for selecting any necessary resolution measures should a back failure beckon, according to a key section of the legislation: “… the Corporation shall […] liquidate and wind-up the affairs of a covered financial company, in such manner as the Corporation deems appropriate […]” .
Unlike the sole agency model under the DFA, the European regulatory architecture is inevitably more complex with resolution powers vested in a network of players including the:
- Single Resolution Board;
- National Resolution Authority;
- Single Supervisory Mechanism (part of the European Central Bank); and,
- European Commission Directorate-General for Competition.
Officially introduced in January 2016, the BRRD established a common approach within the European Union (EU) to coordinate the recovery and resolution of troubled banks.
The BRRD has four resolution tools at its disposal, namely:
- Sale of business – total or partial disposal of an entity’s assets, liabilities and/or shares to a private purchaser;
- Bridge bank – part or all of the assets, liabilities and/or shares are transferred to a controlled temporary entity;
- Asset separation – assets can be transferred to an asset management vehicle (AMV); and,
- Bail-in – equity and debt can be written-down and converted, placing the burden on the shareholders and creditors of a bank, rather than on the public.
Good bank, bad bank: some EU examples
Figure 1 below lists in a non-exhaustive way some of the more remarkable resolution cases in Europe to date, both pre- and post-BRRD.
Figure 1. Examples of European bank resolution
Banco Espirito Santo
Split into a good/bad bank; pre-BRRD.
Four regional banks
Bridge bank/asset separation; the Italian resolution fund provided €3.6bn of fresh capital.
Four senior bonds (€2bn) moved to bad bank; pre-BRRD.
Banco Popular Espanol
Sale of business for a symbolic €1 to Santander.
Vicenza/ Veneto Banca
Split good/bad bank; Sale of business – Intesa was paid €3.5bn of Italian taxpayer funds to take over its ‘good’ assets.
Source: Federated Hermes, as at April 2021.
In November 2015 the new EU resolution powers were ‘stress-tested’ when authorities intervened to rescue four Italian regional banks – Banca Marche, Banca dell’Etruria e del Lazio, Cassa di Risparmio di Ferrara, and Cassa di Risparmio della Provincia di Chieti – that had been placed under administration.
The EU resolution plan included the creation and capitalisation of four bridge banks to house the good assets of these institutions. Meanwhile, the (remaining) equity and subordinated debt of Banca Marche were left behind in the bad bank.
Eventually, the banks were sold back to the private sectors but the burden-sharing on the subordinated bonds, at the time mostly owned by the banks retail depositors, created mayhem.
The resolution exercise was unique in combining the application of the bridge bank tool with the set-up of an AMV to absorb impaired assets from the bridge banks.
Later in Spain the Banco Popular resolution followed a much simpler wind-up path with the bank’s Tier 2 and Additional Tier 1 debt set to zero before selling the business for a symbolic €1 to Banco Santander.
Importantly, both layers of the Banco Popular subordinated bonds had the same, very low recovery.
The BRRD also includes measures designed to spread bank losses equitably among bond-owners and shareholders through the ‘no creditor worse off’ (NCWO) principle enshrined in the 2014 directive.
Under the NCWO, any EU bank resolution must ensure that no creditors or shareholders suffer greater losses than would have been the case in normal insolvency proceedings.
More than five years after the BRRD formally came on-stream the European Commission has embarked on a review of the resolution rules with one of its most ambitious objectives to improve outcomes for creditors and depositors in any bank failure.
To date, though, policy-makers have struggled to link the aim of bolstering the bank resolution process with a pan European deposit guarantee scheme.
Undoubtedly, the regulatory efforts to set the ground-rules for managing, or preventing, future bank runs has have given a certain level of assurance about the resilience of the core global financial system.
Regardless, investors should follow the Doomsday Argument lead and at least try to estimate the odds of future financial extinction for any particular institution based on both ‘probability of default’ as well as the ‘loss given default’.
Given we now have recent historical examples of how the post-GFC banking resolution process works, we can also ignore the advice imparted by George Banks in Mary Poppins to: “Kindly do not attempt to cloud the issue with facts.”
Intellect with interest
« If you want to make an apple pie from scratch, you must first invent the universe. »