The Dark Side of Bank Resolution: Counterparty Risk through Bail-in
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, International and Comparative | 0

By Wolf-Georg Ringe and Jatine Patel (University of Hamburg – Institute of Law & Economics, University of Oxford)

Bail-in and its supplementary capital requirements have much touted potential. Beyond their promise to reign in financial institutions’ bail-out moral hazard, bail-in intends to stem systemic risk whilst maintaining “critical” banking functions. It seeks to do this by allocating responsibility for recapitalization of banks to their individual creditors, immediately upon resolution, and in a pre-defined manner, for each financial institution individually. Counterparties to banking capital are therefore intrinsic to the current regulatory framework.

In our recent paper, we show, however, that bail-in legislation may have had counterproductive effects. Our key finding is that the introduction of bail-in has led to increased interconnectedness among banks, which involves more rather than less systemic risk. Worse still, increased interconnectedness between banks may jeopardize the effectiveness of the bail-in regime altogether since resolution authorities may be reluctant to exercise bail-in powers in the face of highly interconnected and contagious banks.

Using a difference-in-differences methodology, we provide evidence for this from the introduction of bail-in powers at the Eurozone level on January 1, 2016 when it entered into force under the European legislation known as the Bank Recovery and Resolution Directive, and the corresponding Single Resolution Mechanism (as part of the Banking Union) became effective. Using data from the European Central Bank’s Securities Holdings Statistics, we demonstrate that beginning in early 2016, financial institutions’ investments in securities issued by other financial institutions has been following a markedly increasing rate. What is more, at the same time non-banks have continued to decrease their investments in the same issuances. Put differently, banks’ holdings of securities in each other increased following the introduction of bail-in legislation, while non-banks continued to divest their holdings of bank securities.

We interpret these findings as evidence of a relative cost advantage that financial institutions have in comparison with other investors when investing in banks’ securities. We know from prior literature that increased interconnectedness may stabilize the banking sector for small external shocks (Acemoglu et al. 2015). For large, systemic shocks, in contrast, bank interconnectedness may frustrate any bail-in decision due to the systemic risk it creates (Bernard, Capponi, and Stiglitz 2017).

We subsequently discuss the challenges in regulating this problem, noting that in addition to the incentive problems mentioned above, there are also extensive knowledge and incentive challenges. Those challenges are symptomatic of the same legal and economic difficulties expressed in the literature and evident in recent bail-in cases.

Whilst some aspects of the current regulatory framework, including the Basel III and the TLAC framework, and standardized information disclosure under IFRS 9, indirectly affect those knowledge and incentive issues, they insufficiently address the bail-in counterparty problem especially because those measures address pre-resolution systemic risk perceptions, and not post-resolution systemic risk. More crucially perhaps, they do not facilitate optimization, or the who should hold corollary.

Finally, we explore some potential regulatory supplements to the current framework that may assist in reducing the challenge of knowing who should hold banking issuances, particularly ensuring that markets are better informed and able to allocate banking securities to optimal holders in accordance with principles of portfolio management, as opposed to attempting to prescribe ideal holders. More analysis and further holistic research are required to understand better what combination of regulatory instruments would be appropriate.

The full article is available here.

Bankruptcy Forum Shopping in Europe
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Wolf-Georg Ringe (University of Hamburg – Institute of Law & Economics; University of Oxford – Faculty of Law).

Over the past several years, European firms have been active in cross-border arbitrage to benefit from a more favorable bankruptcy regime. The European Insolvency Regulation (EIR), an instrument determining the competent courts and the applicable law in EU cross-border insolvency proceedings, has long sought to curb such efforts. A major reform which came into force in 2017 has the specific objective of further restricting abusive versions of forum shopping, in particular by introducing a three-month “suspension period” for forum shopping activities carried out shortly before the debtor files for insolvency.

In a recent article, I demonstrate that these efforts fail to achieve a satisfactory response to forum shopping. The key element of the reform, the suspension period, is both over-inclusive and under-inclusive in its scope of application and may, at best, be entirely without effect. The new rule will also create significant uncertainty and undermine effective ways of business restructuring.

Meanwhile, the reform does not address new variants of forum shopping, such as the use of the British “scheme of arrangement” by continental European firms. Such “procedural” forum shopping may be effected entirely without any physical relocation, as it does not come within the scope of application of the EIR.

The laudable goal of the EIR to improve the pricing of risks in cross-border insolvencies is jeopardized where the rules on jurisdiction are unclear or uncertain. The 2017 reform is a missed opportunity to improve the system by attaching substantive bankruptcy law and jurisdiction to a company’s registered office as the only clear and predictable connecting factor. Instead, the reform introduces new riddles and inconsistencies. Such steps will blur rather than improve the pricing of insolvency risk and thereby ultimately drive up the cost of capital.

The full article is available here.