Systemic risk and the optimal seniority structure of banking liabilities

• Author: Spiros Bougheas,Alan Kirman
• Published date: 01 January 2018
• Date: 01 January 2018
• DOI: http://doi.org/10.1002/ijfe.1602

Received: 16 October 2017 Accepted: 12 December 2017

DOI: 10.1002/ijfe.1602

RESEARCH ARTICLE

Systemic risk and the optimal seniority structure of

banking liabilities

Spiros Bougheas1Alan Kirman2

1School of Economics, University of

Nottingham, University Park, Nottingham

NG7 2RD, United Kingdom

2École des Hautes É tudes en Sciences

Sociales, CAMS - EHESS 190–198, avenue

de France, 75244 Paris Cedex 13, France

Correspondence

Spiros Bougheas, School of Economics,

University of Nottingham, University Park,

Nottingham NG7 2RD, United Kingdom.

Email:

spiros.bougheas@nottingham.ac.uk

JEL Classification: G21; G28

Abstract

The paper argues that systemic risk must be taken into account when design-

ing optimal bankruptcy procedures in general, and priority rules in particular.

Allowing for endogenous formation of links in the interbank market, we show

that the optimal policy depends on the distribution of shocks and the severity of

fire sales.

KEYWORDS

banks, priority rules, systemic risk

1INTRODUCTION

An important issue that the design of any bankruptcy

procedure must resolve is the allocation of priority rights

among the various claimants of the corresponding entity's

assets. By definition, the value of the assets of a bankrupt

entity is below the value of its liabilities and, therefore,

a rule is needed for allocating those assets to the vari-

ous claimants. Often, the allocation of priority gives rise

to a complex hierarchy among the creditors having at

the top holders of secured debt and right down at the

bottom, the providers of equity. There is an extensive lit-

erature in financial economics1that studies the optimal

design of bankruptcy procedures. The main aim of the

design is to make investment attractive to creditors by

shifting sufficient risk on those agents who have control

over decision-making. In a setting with multiple stages

of financing by multiple creditors, the design of priority

rights takes the form of a hierarchical structure.

A policy area that has attracted a lot of attention, espe-

cially in the aftermath of the 2008 crisis, is the design of pri-

ority rules for banks. What is striking is the variety of rules

applied around the globe (Lenihan, 2012; Wood, 2011).

Many countries in response to the crisis have either only

recently introduced or are in the process of introducing

depositor preference rules. These include Greece, Portu-

gal, Hungary,Latvia, and Romania that have to implement

such rules as part of the conditions that they need to

meet in order to participate in EU/International Monetary

Fund programmes. In the UK, the Vickers report recom-

mends the introduction of a depositor preference rule (ICB

Report 2011).The arguments supporting the rules in place

are mainly about the incentives that these rules provide to

depositors and other creditors to monitor the activities of

banks. The lower a creditor is on the priority list, the less

likely is that he/she will receive (at least full) compensa-

tion in the case of bankruptcy, and therefore, the stronger

are his/her incentives to ensure that the borrower does

not take excessive risks. Although nobody disagrees with

the validity of the last statement, there is substantial vari-

ation in opinions about which is the most suitable party to

perform the monitoring service.

In this paper, we argue that systemic risk is another

aspect of banking that must be taken into account when

designing bankruptcy procedures. In general, the design of

optimal priority rules is focused on the welfare of a bank's

creditors, namely, its depositors, other debt holders, and

equity owners. However, when systemic risk is a concern,

the design must also take into consideration the welfare

of third parties and, in particular, all those who provided

Int J Fin Econ. 2018;23 47–54. wileyonlinelibrary.com/journal/ijfe Copyright© 2018 John Wiley & Sons, Ltd. 47: