3. Are Banks Special? Implications for Bank Bankruptcy Law

Ayotte and Skeel (2010) argue that, even though bankruptcy law can effectively be used in the failure of a financial institution, special amendments are needed for systemically important firms. We argue that special amendments may not be enough and special bank bankruptcy legislation is more suitable for addressing the special features of bank failures.

See Bryant (1980), Diamond and Dybvig (1983), Rochet and Vives (2005). Goldstein and Pauzner (2005) evaluate the probability of a bank run based on the coordination problem between depositors and economic fundamentals. Bhattacharya et al. (1998) provide a comprehensive overview of the rationales for regulation in the context of the fragility of financial intermediaries.

See Calomiris and Kahn (1991), Chari and Jagannathan (1988), and Jacklin and Battacharya (1988).

Swagel (2009) discusses political constraints in passing the Troubled Assets Relief Program through the U.S. Congress.

See Allen and Gale (2000), Chari and Jagannathan (1988), Dasgupta (2004), Diamond and Rajan (2005), Freixas and Parigi (1998), and Freixas et al. (2000) for theoretical models of financial contagion. Empirical evidence for contagious effects of banks failures is provided by Iyer and Puri (2010), Kelly and O’Grada (2000), and Saunders and Wilson (1996). Not only coordination problems but also a combination of competition and information problems among banks make the banking industry highly susceptible to credit booms and credit crunches, exacerbating systemic risk; see Dell’Ariccia and Marquez (2006) and Gorton and He (2008).

See Bernanke (1983) for an argument that banking crises deepened the severity of the Great Depression.

Reinhart and Rogoff (2010b) find that in the decade after the crisis GDP growth is significantly lower and unemployment higher compared to the decade before the crisis. Bordo et al. (2001) find that during the last 120 years the frequency of crises has increased and crisis probability has more than doubled since 1973. Lindgren et al. (1996) identify 133 countries facing banking problems between 1980 and 1996. Gorton (1988) analyzes panics during the U.S. National Banking Era from 1865 to 1914. Honohan and Laeven (2005) document banking crises throughout the world since 1970. Calomiris and Manson (2003), Caprio and Klingebiel (1996), Dell’Ariccia et al. (2008), Honohan and Klingebiel (2003), Lindgren et al. (1999), and Ongena et al. (2003), document the costs of these banking problems. Comprehensive surveys on banking crises include Allen and Gale (2007), Bhattacharya and Thakor (1993), Freixas and Rochet (1997), and Gorton and Winton (2003).

In March 2008, Bear Stearns essentially experienced a bank run from hedge funds, which pulled out their liquid assets. In September 2008, a “silent bank run” occurred on Washington Mutual, in which several large depositors depleted their accounts to a level below the federal insured level of $100,000. In September 2008, several counterparties demanded additional collateral from AIG on its credit default swaps. Such requests would have brought down AIG and the public intervention was necessary (Brunnermeier, 2009).

Ivashyna and Scharfstein (2008) provide evidence that borrowers drained their loan commitments in the current financial crisis. Borrowers may have done this because they expected banks not to be able to continue lending.

See Goodhart and Shoenmaker (1995) for a survey of resolution policies during 104 bank failures.

Upon the Lehman Brothers bankruptcy in 2008, the Federal Reserve had to lend aggressively to all the banks in the system in order to avoid the collapse of the financial markets.

This soft-budget-constraint problem is not limited to banks. Large corporations may also become too big to fail and the government may be forced to rescue them. However, interconnections between banks and systemic concerns thus induced create greater negative externalities for the economy at large.

Banks may confront the opaqueness and risk shifting problem themselves by funding through deposits withdrawable on demand. The threat of a bank run may put discipline on a bank’s management not to engage in excessive risk (Calomiris and Kahn 1991; Flannery 1994). Insuring deposits and/or providing implicit guarantees then destroy the benefit of the pressure of demand deposits.

See Acharya et al. (2010c) for policy proposals to charge prudential levies on strategies exposed to systemic risk.

Diamond and Rajan (2001) argue that demand deposits prevent expropriation of excessive rents by the bank and by its borrowers.

Iannotta (2006) also provides evidence that, when controlling for risks, credit-rating agencies give split ratings to banks more often compared to non-financial firms. However, Flannery et al. (2004) use the stock market’s microstructure properties to show that bank stocks are not unusually opaque.

Goyal (2005) shows that subordinate bank debtholders respond to increased risk-taking incentives of a bank by writing restrictive covenants in bank debt.

Campbell et al. (1992) and Mailath and Mester (1994) study the incentives of a single regulator. Kahn and Santos (2001) argue that a single regulator leads to too much forbearance and to insufficient bank monitoring.

Ponce (2010) extends Repullo’s framework by considering the objective of the bank supervisor, while bankers’ optimal actions are endogenously determined. He finds that the unconditional bailout of illiquid banks is socially desirable when shortfalls are large and recommends corrective actions on the bankers if they misbehave.

See Boot and Marinč (2009) for a discussion of the problems pertaining to the supervisory arrangements at the European level.

See Corsetti et al. (2006) and Morris and Shin (2006) for a discussion of how an international financial institution helps preventing liquidity runs through coordination of agents’ expectations.

The role of lobbying groups in politics is described by Olson (1965) and Stigler (1971).

Several empirical studies find evidence that the government ownership of banks is costly for the economy at large due to (for example) politically influenced lending, lower subsequent financial development, and lower growth of per capita income and productivity (La Porta et al. 2002; Sapienza 2004).

In 1999 the failure of First National Bank of Keystone, West Virginia occurred. Its management delayed prompt closure by hiding the bank’s insolvency from banking agency examiners (U.S. Treasury 2000). Huizinga and Laeven (2009) show that banks concealed true losses when in distress, and especially during the 2007–2009 financial crisis. Banks used accounting discretion to overstate the value of real estate-related assets and opportunistically classified mortgage-backed securities to increase the accounting value of assets.

Honohan (2008) argues against mechanical risk-management models. He calls for a discretionary approach towards regulation based on evidence from the 2007–2009 financial crisis.

See Acharya et al. (2009b), Acharya and Merrouche (2009), and Adrian and Shin (2007) for a description of the contagion mechanism in financial markets through fire sales.

Flannery (2005) proposes that banks would finance by issuing “reverse convertible debentures” that would automatically convert to common equity if a bank’s share price falls below some stated value. See also the speech by Thomas F. Huertas, Director, Banking Sector, FSA, ICFR Inaugural Summit, London, 1 April 2009.

Acharya et al. (2010b) show that under certain conditions having sufficiently high Tier 1 capital may mitigate systemic risk that arises due to moral hazard problems. However, under certain conditions it may be optimal to establish a special capital account (e.g., through dividend restrictions) owned by shareholders in good times but by the regulator in bad times.

Flannery (1994) argues that asset-substitution problems are more pronounced for banks than for non-financial corporations. In addition, bank assets are informationally intense and their risk properties are usually not easily described and contracted on, such that conventional mechanisms to limit risk-shifting behavior such as writing covenants may not be sufficient for bank debt.

A recent example of the good/bad bank formation may be the UK bank Bradford & Bingley, which was split into two parts. The mortgage book was nationalized, whereas the deposit book and branch network were sold to a private purchaser; see HM Treasury (2008b).

Kahn and Winton (2004) also argue that the separate structure is viable if cherry picking is not possible. In particular, the good bank should not have incentives to keep some of the risky loans aboard; that is, the profitability of risky loans has to be sufficiently low.

However, in underdeveloped countries government ownership of banks may spur the branching presence in underdeveloped parts of the country and reduce poverty; see Burgess and Pande (2005).

In an opposing view, Cordella and Yeyati (2003) argue that the regulators should commit to bailing out failing banks in the case of a systemic crisis. In their model, however, systemic crisis is exogenously driven and bank behavior cannot change the probability of a systemic crisis. In such a case, ex-ante commitment to bail out banks does not hamper banks’ moral hazard problem. Anticipated bailout policies increase banks’ franchise values and banks even take less risk.

Advantages and disadvantages of these tools are also discussed in Seeling (2006).

In Diamond and Dybvig’s (1983) simple model, freezing deposits (also called suspension of convertibility) seems to be the optimal response to preventing bank runs if the liquidity shocks are i.i.d. among depositors. In this case, the bank only repays an expected proportion of depositors in the first period. Announcing this in advance, depositors anticipate that there will be no losses and are comfortable with leaving their funds in the bank. Consequently, only depositors with early liquidity needs raise their funds. Suspension of convertibility becomes more problematic if liquidity shocks are partially correlated (and/or not fully diversified). In this case, suspension of convertibility induces suboptimal liquidity provision because not all depositors with an early liquidity need are able to withdraw their funds. In the (more realistic) case of information-based bank runs, matters are more complicated. Suspension of convertibility may again lead to a suboptimal liquidity provision (Bhattacharia and Thakor 1993; Chari and Jagannathan 1988).

The example is the rescue of all depositors and even bond holders of Continental Illinois to prevent spreading the risk to another bank. Continental Illinois was considered too big to fail (Morgan and Stiroh 2005; Wall and Peterson 1990).

See Gros (2009), Guha (2009), and Holmes (2009).

Sweden implemented this strategy in the second half of the 1980s. After a credit-fueled economic boom with soaring equity markets and real estate prices, Sweden’s economy dived into a deep recession. Troubled bank assets were 15% of GDP before the “good bank/bad bank scheme” was implemented. See also The Economist Staff (2008).

For example, in the case of bankruptcy the failed bank may be acquired at below its fair price (see Perotti and Suarez [2002] for a model of competition between two banks in which a failure of one bank comes as a benefit for its competing bank because of its newly obtained monopolistic position). In general, however, a bank failure comes as a blow for other banks by damaging public confidence, for example.