The insecurity of the unsecured creditor | FT Alphaville

The insecurity of the unsecured creditor

How do you solve the problem of excessive risk-taking and systemic risk?

FDIC chairman Sheila Bair had an idea back in October:

ISTANBUL (Reuters) – Ensuring secured creditors face losses when a financial institution fails could help rein in excessive risk-taking and strengthen the financial system, a top U.S. banking regulator said.

Federal Deposit Insurance Corp Chairman Sheila Bair told a group of international bankers on Sunday that officials might want to consider “the very strong medicine” of limiting secured claims to 80 percent, although she said such a proposal would need to be carefully weighed.

Which means that if a bank failed share- and bondholders would only get 80 per cent of their investment back.

There’s a bit of federal jaw-boning taking place here. At the moment when a bank fails the Federal Home Loan Banks (FHLBs) have priority over other creditors, including FDIC, which is responsible for insuring US bank deposits. FDIC, according to some sources, has long sought to overturn the FHLBs priority status.

But the basic idea is that secured creditors would more closely monitor the risks the bank is taking if they knew they stood to suffer a 20 per cent haircut on their investment should it fail.

And fast forward a month or so and it looks like Bair’s unsecured idea is gaining traction.

The House Financial Services Committee on Thursday passed an amendment, offered by Democratic representatives Miller and Moore, that included the haircut proposal. (For a round-up of the other amendments, see here).

And the amendment is already generating criticism.

To wit, John Jansen of Across the Curve has picked up a bit of comment from Barclays Capital:

The House of Representatives is working on a draft bill that would more closely regulate large financial institutions in an effort to reduce the systemic risk that pushed the economy deep into recession. The nearly 300-page bill deals with a number of tough issues, including the role of the Federal Reserve in providing credit to non-banks (the “exigent circumstances” clause of the Federal Reserve Act), and, most significantly, establishing rules for the unwinding of a large, systemically important institution. The definition of systemically important institution, however, is subject to a number of interpretations, some of which are outlined in another amendment. But it is generally assumed that any bank or financial institution with more than $10bn in assets would qualify. While no doubt well intentioned, an amendment passed yesterday has significant implications for secured funding markets. Proposed by Reps. Miller (D) and Moore (D), it would effectively replace existing repo and secured funding with unsecured borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%. This discount is meant to raise enough funds to offset any taxpayer losses. In the language of the bill, it establishes a “polluter pays” structure for unwinding a financial institution: the cost of a (hopefully) orderly unwind is fully absorbed by the firm’s shareholders and unsecured creditors — not the taxpayer.

Implications We believe the Miller and Moore amendment would have significant implications for the repo market. It would likely make secured funding to large institutions much more “flighty” — that it, much more volatile and prone to leave quickly. In any situation where it appears that a large firm is about to fail, secured lenders will rapidly head for the exit and terminate as many of their repo transactions as possible. No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount (net of the original haircut). We believe the proposed legislation will also make secured lending far more pro- cyclical — with lenders stepping away from a systemically important institution immediately upon hearing anything that might raise the odds of a FDIC takeover. In our opinion, the combination of flight-prone money and pro-cyclicality would ultimately defeat the intent of this legislation, which is to reduce systemic risk. Instead, large systemically important firms would become more vulnerable to liquidity runs — of the sort seen last fall. In addition, the Miller and Moore amendment would raise funding costs for large institutions, pushing them into the unsecured market and removing an important source of liquidity to the repo market — at precisely when unsecured money is not available.

In a broader sense, the amendment calls into question the legal underpinnings of secured funding. After all, if the repo and other secured funding contracts can be reversed (no pun intended) when a systemically important institution is taken over by the FDIC, might there be other situations in which repo trades would be demoted in a bankruptcy? Obviously, it is too early to forecast the fate of this bill, much less those of the dozen or so attendant amendments. However, like other regulatory efforts — from reforming tri-party repo to recasting how money market funds operate — the Miller-Moore proposal exemplifies the new shift toward heavier regulation in Washington. Striking a happy medium between ensuring financial stability and overly aggressive regulation will prove very difficult next year. As a result, 2010 could be a very bumpy year.

Which is a very interesting point, given that, historically it’s been sophisticated creditors — not retail depositors — who have a tendency to very quickly withdraw their funding when a bank shows signs of being in trouble, thus crippling its operations, and possibly sending it into bankruptcy. Putting those creditors on more uncertain footing could well exacerbate that problem, as Barclays notes.

Of course, if the basic idea of the proposal works — that creditors, knowing they’re in line for a 20 per cent haircut will monitor the risks to the banks they invest in — then in theory banks should never get to that (troubled) point. But that’s a very big if.

Either way — it’s food for thought, and a great illustration of the immense reformatory challenge facing regulators.

Related links:
Ten propositions about liquidity crises – BIS, (H/T Alea)
House amendment poses threat to lending liquidity – The Voice of Housing
Imposing a haircut on unsecured bank creditors – Felix Salmon
Repo-ssessed: Lehman RMBS goes on sale – FT Alphaville