25. Standing Bailout Programs

25.1  Standing Bailout Programs in the European Union and Japan

In the European Union, as a result of the eurozone crisis, and in Japan as a result of the lost decade, standing support programs have been created that can be used to bail out failing banks, and in the case of Japan nonbanks as well, in the future. Other countries such as China effectively guarantee the solvency of banks without setting up a program. The point being that the United States is rather unique in its apparent resolve, however unrealistic it may be, to foreswear any use of bailouts in the future.

25.1.1  Eurozone

Bank stability in the eurozone is of particular importance since bank failures can create sovereign debt crises. Weak banks, especially those that are large compared to national GDP, can spread panic to sovereign debt markets if a solvent sovereign needs to borrow heavily to recapitalize its banks, as was the case of Ireland during the global financial crisis. The problem can also be the reverse. Government debt defaults may lead to bank failures when banks holding sovereign debt need to write it down. In February 2010 German and French banks alone had over $900 billion of exposure to Greece, Portugal, Ireland, and Spain.1

The Single Resolution Mechanism and Single Resolution Fund The eurozone (EZ) crisis led to fundamental changes in the regulation of banking in the EZ. In June 2012, the European Council agreed to create a banking union that would allow for centralized supervision by the ECB (transferring it from national authorities) of large banks through the Single Supervisory Mechanism (“SSM”) and centralized resolution of euro area banks through the Single Resolution Mechanism (“SRM”). The SRM also applies to financial holding companies, investment firms, and other financial institutions that are subject to consolidated supervision by the ECB.2

These actions parallel the US restructuring of bank supervision by centralizing supervision of $50 billion banks, plus nonbank SIFIs in the Federal Reserve System, and creating new resolution authority for systemically important banking organizations under the OLA, as previously discussed. However, unlike the United States, which prevents the government making injections of capital into banks under OLA or FDIC procedures, the EU’s SRM does have this capability.

In connection with SRM, the EZ countries have created a Single Resolution Fund (SRF) to recapitalize failed banks and to provide liquidity financed by bank levies—this is entirely separate from deposit guarantee funds. The SRF will be built up to €55 billion within the next eight years, or 1 percent of total deposits for banks covered by the SRF.3 The SRF is financed ex ante by bank levies raised at the national level and will be kept at the national level for a ten-year transition period.4 First losses of at least 8 percent of liabilities must be covered by bail-ins.5 While the United States rescinded the ability of the FDIC to use its guarantee fund for open bank assistance,6 and designed OLA to impose all losses on private creditors (only liquidity is available through OLF) through the TLAC mechanism, the EZ handles failed banks by a combination of bailout and bail-in, and the bail-out component is pre-funded.7

The European Stability Mechanism In addition to the SRF, the European Union also created a new permanent bailout mechanism in 2010, the European Stability Mechanism (“ESM”), primarily intended to bailout sovereigns. But sovereigns can use loans from the ESM to inject capital into banks. And to a limited extent the ESM can inject capital directly into EZ banks.

The ESM raises funds in capital markets to finance loans to euro area member states. ESM bonds are backed by guarantees provided on a pro-rata basis by each member state. The ESM’s current lending capacity is €500 billion.8 The funds are backed by €80 billion paid-in capital contributed by EZ members in five installments and the ESM has an additional call on the member states for €622 billion—to cover potential losses.9 ESM funding is conditional on reform and austerity measures taken by borrowing states.

There is also authority for ESM to make direct loans to banks, and its funds can also be used to backstop the SRM. The size of this program, the direct bank recapitalization instrument, is capped at €60 billion.10 To be eligible for ESM recapitalization, the bank or its holding company must have exhausted all other sources of funding, private creditors must have been bailed-in, and the bank must have been designated by the ESM Board of Governors as systemically important or likely to pose a serious threat to the financial stability of the euro area.11 The ESM Board of Governors makes such a determination.12 However, there are no publicly available guidelines on the criteria, or how/when such a determination would be made. Although not explicitly required, the ESM has stated that it will only recapitalize institutions “whose viability can be secured through a capital injection and restructuring plan.”13 Direct bank recapitalization is only available after creditors have been bailed-in and the Single Resolution Fund has made a contribution to the bank.14 The recently adopted minimum requirement for own funds and eligible liabilities (“MREL”) consultation outlines minimum levels of debt that will be available for bail-in.15

The major point about the EU approach is that it uses pre-funded bailouts of banks as a major way of dealing with insolvent or inadequately capitalized banks. The procedures for using these funds in resolution are being developed in detail, so that a full and transparent system will be on the shelf. Thus the European Union not only has a strong lender of last resort, it also is ready to inject capital into failing banks if warranted.

25.1.2  Japan

The Japanese government also has standing authority to use public funds to recapitalize solvent banks and solvent financial institutions. The Japanese government further has the authority to nationalize insolvent banks and to provide limited assistance to insolvent financial companies. The government is also permitted to nationalize an insolvent financial institution following a systemic risk determination.

Capital Injections for Banks Chapter VII-1 (“Measures against a Financial Crisis”) of the Deposit Insurance Act (“DIA”), provides the Deposit Insurance Company of Japan (“DICJ”) with the authority to inject capital into solvent banks, provided that the Prime Minster determines that failing to do so would create a serious risk to financial stability.16 The government is also permitted to temporarily nationalize an insolvent bank following a similar systemic risk determination.17 Of course, nationalization would also lay the predicate for a capital injection.

Chapter VII-1 was adopted in 2000, after a wave of large bank failures during the Asian financial crisis illustrated the need for extraordinary intervention during crisis periods. The DIA generally seeks to resolve troubled banks through either an insurance payoff approach in which the bank is liquidated and insurance proceeds are paid to protected depositors; through a purchase and assumption transaction; or through the establishment of a bridge bank in anticipation of finding a buyer for a purchase and assumption transaction.18 In the second and third cases, the DICJ is authorized to provide financial support up to the equivalent amount that would be paid in an insurance payoff approach through, for example, loan guarantees to the bridge bank.19

The systemic risk exception of Chapter VII-1 grants the DICJ authority, when the Prime Minister, in consultation with the Council for Financial Crises, determines that exercising exceptional authorities is necessary to “maintain … an orderly credit system,”20 to provide support in excess of the amount that would be paid in an insurance payoff approach.21 If the bank is solvent, the DICJ is specifically authorized to use public funds to recapitalize the bank or underwrite its stock issuance.22 Chapter VII-1 does not include any express limitations on the maximum amount of capital that can be injected into a solvent bank. It also does not specify the source of public funds for recapitalization, although it will presumably draw on the deposit insurance fund if necessary. In this sense, the exceptional measures permitted under the systemic risk exception may be partially pre-funded. But prefunding is much more limited than in the EU.

Public capital injections are unavailable to nonbanks under Chapter VII-1. This generally includes a trouble bank’s nonbank affiliates. However, the DICJ is permitted to temporarily inject capital into a holding company of a bank, provided that the holding company uses the proceeds to recapitalize the bank subsidiary.23 Chapter VII-1 authorities were used in 2003, when the DICJ acquired approximately 70 percent of voting shares in Resona Bank for roughly $20 billion.24

If a bank is insolvent and the Prime Minister, in consultation with the Council for Financial Crisis, has made a systemic risk determination, the troubled bank can be temporarily nationalized.25 The most important characteristic of nationalization is that existing shareholders are completely wiped out, an approach whose possible virtues we have previously discussed. For example, in 2003 Ashikaga Bank was temporarily nationalized to avoid financial crisis. The DICJ used approximately $4 billion from the deposit insurance fund to lend to the failed institution, and to purchase some of its assets.26 Public funds were repaid when Ashikaga was purchased by a consortium in 2008.27

Capital Injections for Solvent Financial Institutions Whereas Chapter VII-1 only applies to banks, Chapter VII-2 of the DIA grants the DICJ a broad array of special authorities over financial companies. Under limited circumstances these authorities include an ability to use public funds to recapitalize a distressed firm or to guarantee its debt. Financial companies covered by Chapter VII-2 are defined as banks, bank holding companies, subsidiaries of banks and holding companies, insurance companies and their subsidiaries, securities firms, and the parent companies and subsidiaries of certain large securities firms.28 So banks can be dealt with under either Chapter VII-I or II.

Once Chapter VII-2 is triggered with respect to a specific financial company, the troubled financial company “must submit to oversight by the DICJ.”29 If the firm is solvent, then the DICJ can provide it with liquidity or guarantee its debt.30 Subject to additional approval by the Prime Minister, the DICJ is also authorized to use public funds to recapitalize the solvent firm or underwrite a share issuance.31 A firm is solvent if it is able “to satisfy its obligations in full with its assets,” it is not “likely to face a situation where it is unable to satisfy its obligations in full with its assets,” it has not “suspended payment of obligations,” and it is not “likely to suspend payment of obligations.”32 This is a more restrictive standard than the one applicable to Chapter VII-1 recapitalization. Costs of a recapitalization will be recouped by ex post assessments on all financial institutions.33 The assessment can be waived if payment would trigger financial instability.34 Chapter VII-2 does not have an explicit cap on the maximum amount of capital injections, and does not create a pre-funded facility designed for recapitalization.

If Chapter VII-2 is triggered with respect to an insolvent financial company, the DICJ has certain limited authorities to provide the company with financial assistance. For example, the DICJ can transfer “systemically important transactions,” namely transactions whose failure would disrupt the financial system, to a bridge bank.35 In addition the DICJ can lend to the institution to avoid financial instability.36 These authorities do not include nationalization or debt guarantees, as under Chapter VII-1.

25.2  Virtues of Standing Bailout Authority

Advance bailout authority and capability is the third method, along with lender of last resort and guarantees, to deal with a financial crisis. In the United States, while we greatly limited the lender of last resort and guarantee weapons, we did not abandon them altogether as we did with TARP, putting the new OLA resolution procedure, without the possibility of public support, in its place.

This is not sound public policy for designing a stable financial system. Suppose that all of our 8 G-SIBs were insolvent at the same time as a result of an operational failure due to a cyberattack or another form of terrorism? Do we really think the answer would be to put them all in OLA? How about just one, JPMorgan? In my view, a responsible Secretary of the Treasury or the President would not want to do so in either case, whatever the moral hazard implications. And in extreme circumstances, would it not be better for the entire country, the taxpayers, to pay for a failure, with a high prospect of repayment, rather than impose the loss on creditors, which could include major institutions like pension funds and insurance companies (and ultimately the policy holders of such companies)?

So, if we don’t put our heads in the sand, we would design and fund such a capability in advance rather than have our Secretary of Treasury run into Congress at the last minute with a term sheet in hand. At the very least we would design the program in advance (even without funding) to make changes to the approach we used in TARP based on our experience with TARP. Key design issues for consideration would be: First, does it make sense to require all big banks to take assistance for fear of identifying the ones that are insolvent—who was really fooled by this? Second, should we really be giving assistance to every bank, or just systemically important ones? Third, could we combine capital assistance with some degree of private loss, as the EU has the ability to do, even where we would not want to impose total loss? Fourth, how would we value the shares received in return for capital—would we want to assure a market rate of return for Treasury, or not? Fifth, should we close out common shareholders entirely by nationalizing banks, as can be done in Japan, and presumably Europe? Sixth, could we impose more conditions on recipients, including wholesale replacement of top management? Seventh, should we be able to recapitalize banks and other financial institutions before they become insolvent, and if so how? Do we really want to think through these issues in the grip of panic, and where Congress is terrified by voting for an actual bailout under the gun? Some argue that having a plan, and particularly funding it in advance, will just encourage moral hazard. In my view, this concern can be met by deciding in advance what the criteria for its use would be—an extreme circumstance where no other alternative, including most importantly bail-in, is more attractive. And the keys to turn the program on could be very tough. Not only requiring the same actions that are needed to put an institution into OLA, votes by supermajority of the Fed and FDIC, and approval of the Secretary of the Treasury after consultation with the President. It could even include, if necessary, a joint resolution of Congress. That procedure would be far better than what we now have. Who is fooling whom? The market will believe that bailouts will be used in extreme circumstances even if the program is not on the shelf, so it is better to have a good one there than none at all.

And the advance funding would not necessarily involve government appropriations. As is the case with the EZ SRF, the funding could come from assessments on the financial sector, or as in the case of the EZ ESM, come from some government capital leveraged through borrowing authority with a government guaranty.