How To Deal With Failed Banks

IMF Blog, July 3, 2018

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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, creating public resentment and prompting 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.
The study was also featured in an Analytical Corner in the 2018 Spring Meetings.

Not all crises are alike:
- Isolated crises with little or no spillover effect: bail-outs would merely create moral hazard. Resolving a failing bank should rely on bail-ins.
- Systemic crises that affect all corners of an economy or many countries at the same time: destabilizing spillovers from bank failures 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.
Framework implication:
- 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.

Mechanism 1 — Reduce the likelihood and costs of crises by making the banking system more resilient:
- Less leverage and risk taking.
- More capital and liquidity.
- Smaller odds that a bank runs into trouble and greater ability of banks to absorb losses without government help.
Mechanism 2 — Make the bail-in option viable and credible:
- Problem: policymakers may promise bail-ins but be tempted to bail out in a crisis, undermining credibility and maintaining expectations of bail-outs—this produces both spillover and moral hazard effects.

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.
Only allow sophisticated investors who can understand and absorb the losses to hold these bail-in-able claims.
Improve systemic banks’ resolvability by:
- Periodic assessments.
- Living wills that spell out how the bank will be resolved.
- Domestic and cross-border drills to assess the impact of a threat.

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

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.
The IMF supports the ongoing reform agenda and stresses that resolution frameworks should minimize moral hazard while allowing sufficient, albeit constrained, flexibility to use public resources in systemic crises—when spillovers are deemed likely to severely jeopardize macro-financial stability.

Deniz Igan, July 3, 2018