I recently bashed the Bank of International Settlements for having irrational bubble fears. That, however, do not mean that I think that BIS is making bad research. Rather I think that BIS comes out with a lot of interesting research. The latest BIS paper I have read is a paper by Paul Melaschenko and Noel Reynolds on banking resolution.

I find Paul and Noel’s paper very interesting. Here is the abstract:

A proposed creditor-funded recapitalisation mechanism for too-big-to-fail banks that reach the point of failure ensures that shareholders and uninsured private sector creditors of such banks, rather than taxpayers, bear the cost of resolution. The template is simple, fully respects the existing creditor hierarchy and can be applied to any failing entity within a banking group. The mechanism partially writes off creditors to recapitalise the bank over a weekend, providing them with immediate certainty on their maximum loss. The bank is subsequently sold in a manner that enables the market to determine the ultimate losses to creditors. As such, the mechanism can eliminate moral hazard throughout a banking group in a cost-efficient way that also limits the risk to financial stability. The creditor-funded mechanism is contrasted with other recapitalisation approaches, including bail-in and “single point of entry” strategies.

Geoffrey T. Smith over at Real Time Economics provides a good overview of the Melaschenko-Reynolds model:

Authors Paul Melaschenko and Noel Reynolds–both members of the secretariat of the Basel Committee for Banking Supervision–present what they call a “creditor-funded” resolution model. Under it, the authorities take control of a failing bank over a weekend and write down its liabilities immediately to a degree where they consider the new holding company to be well enough capitalized to cope with all expected losses. As equity is the difference between assets and liabilities, it automatically increases, the more the liabilities are written down.

The authorities then issue claims on the new company to shareholders and creditors, equal in rank and size to their previous claims. The resolution authority would then seek buyers for the new bank, having replaced the old bank’s management as it saw fit. Claims on the new bank would be reimbursed from the proceeds of the eventual sale (but there is nothing to stop those claims being traded in the meantime if holders prefer to sell up and cut their losses).

The model essentially blends elements of the “Single Point of Entry” system of bank resolution embraced by the U.S. and UK, and the “Direct Bail-in” approach which focuses on quick recapitalization by the conversion of junior liabilities into equity. The latter is likely to feature prominently when the European Commission presents the new version of its Resolution and Recovery Directive later this month.

But the Melaschenko-Reynolds model includes a number of key refinements. The most important of these, they argue, are that the authorities can immediately provide a good idea of the maximum loss that creditors are likely to incur, and that the market ultimately determines that loss, rather than the administrative decision of hapless bureaucrats working under the unbearable and contradictory pressures of a bank work-out. The need for a firesale of assets is avoided, because the new entity meets all regulatory capital and liquidity requirements, allowing a buyer to be found in (a relative degree of) peace.

Other advantages include the fact that it would largely remove the need for banks to issue hybrid securities, which may help reduce their overall cost of capital. These function as debt as long as the bank is viable, but convert into equity if a bank fails and needs to be resolved. Demand for such instruments has been mixed, as a large part of the universe of bond buyers either doesn’t want or isn’t allowed to act as the part-owner of a bank. That restricts the circle of potential buyers. Under the BIS model, bond investors could hold bank debt knowing that, even in the event of a failure, they would receive debt instruments from the new bank instead of equity claims.

I like it! I think that we have massive moral hazard problems in the the global financial industry and these problems needs to be seriously reduced. I think the Melaschenko-Reynolds model for banking resolution provides a very good starting point for this work.

PS if we get monetary policy right then a lot of banking sector problems disappear, but that is another story…