An approach for initiating interventions for bank recovery

Author:Charles A.E. Goodhart, Miguel A. Segoviano
Position:Financial Markets Group, London School of Economics and Political Science, London, UK
Pages:360-380
SUMMARY

Purpose This paper proposes an objective metric to trigger bank recovery. Banks’ living wills involve both recovery and resolution. Since it may not always be clear when recovery plans or actions should be triggered, there is a role for an objective metric to trigger recovery. Design/methodology/approach We outline how such a metric could be constructed meeting criteria of... (see full summary)

 
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An approach for initiating
interventions for bank recovery
Charles A.E. Goodhart
Financial Markets Group, London School of Economics and Political Science,
London, UK, and
Miguel A. Segoviano
MCM, International Monetary Fund, Washington, DC, USA
Abstract
Purpose This paper proposes an objective metric to trigger bank recovery. Banksliving wills involve
both recovery and resolution. Since it may not always be clear when recovery plans or actions should
be triggered,there is a role for an objective metric to trigger recovery.
Design/methodology/approach We outline how such a metric could be constructedmeeting criteria
of adequate loss absorption; distinguishing between weak and sound banks; little susceptibility to
manipulation;timeliness; scalable from the individual bank to the system.
Findings We show howthis would have worked in the UK, during 2007-2011.
Originality/value This approach has the added advantage that it could be extended to encompass a
whole ladderof sanctions of increasing severity as capital erodes.
Keywords Bank resolution, Bank recovery, Loan default, Loss absorption, Metrics for triggers,
Probability of distress
Paper type Research paper
1. Introduction
The European Banking Authority is currently consulting on standards for bank recovery
and resolutionplanning (www.eba.europa.eu/regulation-and-policy/recovery-and-resolution).
Not only are the separate stages of recovery and resolution commonly linked together in
discussions of nancial regulation and international standards (e.g. the Key Attributes of
EffectiveResolution Regimes for FinancialInstitutions), butalso everyone would prefer that
a bank recovers,rather than has to be placed in resolution.
This suggests to us that more emphasis should be placed on the determination of, and
threshold for, the recovery stage. Whereas there has been much discussion, on triggers for
resolution, it may not alwaysbe clear when recovery plans or actions should be triggered[1].
The purpose of this paperis to try to ll that lacuna.
First, bankers, if left to themselves, are likelyto enter the recovery stage voluntarily far
too late. A concern about reputation, should the news leak (reputational stigma), and the
likelihood that top management will be overly self-condent in their ability to keep going
successfully (think of Fuld and Goodwin), will combine to make management reluctant to
call time on themselves. Second, since there has been little, or no, prior work on deriving a
quantiable metricto signal the trigger for entry into the recovery stage, the intention of this
paper is to do so following a systematic scienticapproach.
JEL classication G21, G28, G33
JFRC
25,4
360
Journalof Financial Regulation
andCompliance
Vol.25 No. 4, 2017
pp. 360-380
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-01-2017-0005
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
We see our objectives for establishing a metric(s) for initiating the recovery phase as
several. First, the metric should capture the adequacy of banksloss absorption buffers.
Second, we want a criterion that distinguishes between weak and sound banks. That is, it
captures all (banks) that are facing a seriouslikelihood of subsequent failure (unless turned
around) i.e. few type I errors. However, we want that criterion to catch relatively few
soundbanks, i.e. that would have survived anyway, type II errors (though sincerecovery
is less irreversible than resolution we would give relatively more weight to type I errors in
this trade-off). Third, we would want the metric to embed little susceptibility to
manipulation; it should be based on observable, veriable and objective data. Fourth, we
would want the trigger for recoveryto occur long enough before continuing problems lead to
resolution to give those concerned, i.e. the bank managers and their supervisors, time and
opportunity to turn the bank around before resolution has to take place, and fth, since
banks are not isolated entities, we would like the methodologyto account for extreme losses
potentially suffered by vulnerablebanks due to the banksinterconnectedness to the system
(systemic risk)[2].We discuss in the following sections how this may be achieved.
2. Bank recovery
The so-called Living Willsof banks have two elements, recovery as well as resolution.
Most of the discussion to date has been related to the triggers for resolution. But the
recovery phase precedes the onsetof any need for resolution. Focusingon the timing/trigger
for the start of the recovery phase has several advantages. First, it can be done by the
application of a more objective metric. The use of accounting measures of capital leads to
long delays in the recognitionof problems and can be manipulated. It has never been even a
good coincident measure of difculties, let alone an early warning. The advantage of
addressing the question of setting an appropriate trigger for the recovery phase is that,
somewhat surprisingly, we know of no one else who has done this. There is no accretionof
prior received doctrineto dismantle. We can proceed to do this by as scientic a metric as we
can derive.
Clearly entry into the recovery phase is a serious business, and quite traumatic for
management, if only because there is always a danger that the news may leak, leading to
reputational damage. Left to themselves,managers would be inclined to defer leaving entry
into this phase far too late. On the other hand, because it is a serious step, it should not be
initiated until there is a serious chance, without a major change of direction, of subsequent
failure. What one wants is a metric which catchesalmost all banks that are likely to fail, or
would have failed without recapitalization (or major surgery) (i.e. almost no type I errors),
and relatively few banksthat survived without outside help (some, but not too many, typeII
errors), and does so early enough to give a reasonable chance to turn the business around
before failure andresolution become inevitable.
Such a metric has additional advantages. By occurring several months prior to the
onset of any resolution, should the latter nevertheless become necessary, it would give
supervisors the opportunity and time to work with the bank in difculties. It could also
represent the minimum level at which a (high-trigger) Contingent Convertible Capital
Instrument might kick in. On the other hand, because of reputational risk and market
manipulation, it would be desirable that the trigger for entry not be publicly
observable. While we believe that the principle whereby this trigger should be set
should be known to all, the actual numerical parameters should be a matter of private
discussion between each bank and the supervisor, with the supervisor having the right
of determination when there is a dispute.
Initiating
interventions
for bank
recovery
361

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