IMF: How To Deal With Failed Banks

Seminar – Restoring Trust by Curbing Corruption. International Monetary Fund Managing Director Christine Lagarde (3rd Left) joins a seminar on “Restoring Trust by Curbing Corruption” with moderator Greg Ip (L), Finance Minister of Paraguay Lea Gimenez Durate (2nd L), Benin Minister of Planning and Development Abdoulaye Bio-Tchane (3rdR), Secretary of State for International Development Penny Mordaunt (2nd R) and Managing Director of the International Secretariat of Transparency International Patricia Moreira (R) during the IMF/World Bank Spring Meetings at the IMF Headquarters April 22, 2018. IMF Staff Photo/Stephen Jaffe.

This article is brought to you in association with the International Monetary Fund

Written by Deniz Igan, July 3, 2018

During the global financial crisis, policymakers faced a steep trade-off in handling bank failures. Using public funds to rescue failing banks (bail-outs) could weaken market discipline and lead to excessive risk taking—the moral hazard effect.

Letting private investors absorb the losses (bail-ins) could destabilize the financial sector and the economy as a whole—the spillover effect. In most cases, banks were bailed out.

This created public resentment and prompted policymakers to introduce measures to shift the burden of bank resolution away from taxpayers to private investors.

“Resolving a failing bank should rely

on bail-ins: private stakeholders

should bear the losses”

Our recent study, also featured in an Analytical Corner in the 2018 Spring Meetings, looks at the question of what to do when a bank fails.

We advocate a resolution framework that carefully balances the moral hazard and spillover effects and improves the trade-off. Such a framework would make bail-outs the exception rather than the rule.

Balancing moral hazard and spillover effects

Not all crises are alike. Some are isolated, with little or no spillover effect. In those cases, bail-outs would merely create moral hazard. Resolving a failing bank should rely on bail-ins: private stakeholders should bear the losses.

Other crises are systemic, and affect all corners of an economy or many countries at the same time.

The destabilizing spillovers associated with bank failures in such a situation would justify the use of public resources: moral hazard still exists but is bearable compared to the alternative of a severe crisis that hurts all, including those without a stake in the troubled bank.

So, the framework should commit to using bail-ins in most cases and allow use of public funds only when the risks to macro-financial stability from bail-ins are exceptionally severe.

Improving the trade-off

The best way to avoid such dilemmas is to reduce spillovers and the need for bail-outs in the first place. This can be achieved through two mutually re-enforcing mechanisms.

The first mechanism is reducing the likelihood of crises and minimizing costs should a crisis occur. This translates into having a more resilient banking system: less leverage and risk taking, and more capital and liquidity. Then the odds that a bank runs into trouble are smaller. And, if there is trouble, banks can absorb the losses without help from the government.

The second mechanism is making the bail-in option viable. The problem is that policymakers may make the promise to bail in a troubled bank but, in a crisis, they will be tempted to bail them out. So people will not believe that bail-ins will happen and continue to expect bail-outs.

This is the worst of both worlds, because it has spillover and moral hazard effects.

How do policymakers make a credible commitment that there really will be bail-ins?

First, ensure that banks have enough buffers to absorb losses and clarify upfront which investor claims (such as bonds and deposits) will in the event of failure be written down and in what order. Second, only allow sophisticated investors who can understand and absorb the losses to hold these bail-in-able claims. Third, improve systemic banks’ resolvability by periodic assessments, living wills that spell out how the bank will be resolved, and domestic and cross-border drills to assess the impact of a threat.

Turning to the other side of the trade-off, how do we limit moral hazard?

First, credibly commit to using bail-outs only in exceptional cases and on a temporary basis with a clear exit plan. Second, use public funds only after those that can absorb the losses have been bailed in. Third, recover these bail-out funds after the storm has passed and ensure that all is executed in a transparent, accountable manner.

The way forward

Reforms since the crisis have improved the trade-off by seeking to make bail-ins a credible option and to make bail-outs less likely.

New frameworks—such as those in the United States and the European Union—introduce comprehensive powers to resolve banks, including through bail-ins. These measures also seek to contain spillovers from bail-ins by ensuring that banks have adequate buffers to absorb losses, and aim to make them more resolvable via effective resolution planning.

We support the ongoing reform agenda and stress that resolution frameworks should minimize moral hazard. That said, we also emphasize the need to allow for sufficient, albeit constrained, flexibility to be able to use public resources in systemic crises—when spillovers are deemed likely to severely jeopardize macro-financial stability.

Deniz Igan is Deputy Chief of the Macro-Financial Division in the IMF’s Research Department. Previously, she worked in the IMF’s Western Hemisphere and European departments. Her research interests include corporate finance, banking, real estate markets, and political economy. She holds a PhD from Princeton University.

the sting Milestone

Featured Stings

Can we feed everyone without unleashing disaster? Read on

These campaigners want to give a quarter of the UK back to nature

How to build a more resilient and inclusive global system

Stopping antimicrobial resistance would cost just USD 2 per person a year

These are the world’s most fragile states in 2019

What Keynes can teach us about government debt today

ECB steadily continues monetary easing policy as EU economy gains momentum

IMF’s Lagarde: Estimating Cyber Risk for the Financial Sector

COVID-19 tracing apps: MEPs stress the need to preserve citizens’ privacy

Building an Inclusive ICT Innovation Ecosystem

Malta: Human rights experts call for justice in case of murdered journalist

Wind farms now provide 14% of EU power – these countries are leading the way

EU budget 2019 approved: focus on the young, innovation and migration

Yemen: ‘Living hell’ for all children, says UNICEF; Angelia Jolie calls for ‘lasting ceasefire’

Earthquake: Monte Dei Paschi Di Siena

Summer 2019 Economic Forecast: Growth clouded by external factors

The sad plight of fledging doctors

UN experts decry torture of Rakhine men and boys held incommunicado by Myanmar’s military

MWC 2016 LIVE: Telenor CEO calls on operators to embrace Mobile Connect initiative

Holocaust survivors rebuild lives and traditions in Rio de Janeiro

Does the world have strong enough institutions to handle risks like Trump and Brexit?

‘Air bridge’ vaccination operation begins for Ebola-hit communities in DR Congo

Over 85% of European bathing sites rated as excellent for water quality

Why do medical students need to emigrate to become doctors in 2017?

EU Commission: Growth first then fiscal consolidation

Pay packet inequality growing worldwide, says new UN report

EU job-search aid worth €9.9m for 1,858 former Air France workers

European Agenda on Migration: Still fragile situation gives no cause for complacency

Infringement – Commission takes Italy to Court for its incomplete regime of access to genetic resources

In Finland, speeding tickets are linked to your income

What can Darwin teach the aviation industry about cybersecurity?

EU budget 2021-2027: Commission calls on leaders to set out a roadmap towards an autumn agreement

More efforts needed to boost trust in business and finance

Resolving banks with depositors’ money?

INTERVIEW: ‘Defend the people, not the States’, says outgoing UN human rights chief

COVID-19 has accelerated India’s digital reset

Why cities hold the key to safe, orderly migration

Prevention is key to ‘breaking the cycle of HIV transmission’, UN chief tells General Assembly

UN must bring more women police officers into the fold to be effective – UN peacekeeping official

UN chief lauds Fijians as ‘natural global leaders’ on climate, environment, hails ‘symbiotic relationship’ with land and sea

Getting vaccinated should just be considered a human right?

Tuesday’s Daily Brief: #GlobalGoals progress, essential meds, updates from Cox’s Bazar, Sudan and DR Congo

On European immigration: Europe’s Missing Citizens

Confirmed ‘Blue Line’ tunnels ‘do not appear’ to surface in Israel – UN peacekeeping chief

Burundi: Inclusive dialogue ‘only viable option’ for resolving country’s political crisis says, UN envoy

Military escalation will have ‘serious consequences’ for Yemeni civilians, warns UN Special Envoy

With 10 million Yemenis ‘one step away from famine’, donors pledge $2.6 billion

Eurozone: Sovereign debt decreases for the first time since 2007

‘Champion for multilateralism’ readies to hand over UN General Assembly gavel

How to bring precision medicine into the doctor’s office

How to survive and thrive in our age of uncertainty

These countries are driving global demand for coal

From cheeseburgers to coral reefs, the science of decision-making can change the world

How women in developing countries can harness e-commerce

Governments can fight corruption by joining the digital payment revolution

The megatrend that will shape our working future

African economies sustain progress in domestic resource mobilisation

Vulnerable children face ‘dire and dangerous’ situation on Greek island reception centres, UNICEF warns

World ‘not yet on track’ to ensure children a better future: UN rights chief

MWC 2016 LIVE: Ingenu steps up efforts to build LPWA networks across the globe

Remarks by H.E. Ambassador Zhang Ming At the Reception in Celebration of the 70th Anniversary of the Founding of the People’s Republic of China

Parliament approves €500 million for schooling of refugee children in Turkey

Libya: UN Mission condemns deadly attack against police in country’s south-east

United States: UN chief ‘deeply saddened’ by deadly California wildfires

More Stings?

Advertising

Comments

  1. vanwoodard says:

    Nice post, well said

Speak your Mind Here

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s