Bank Resolution Costs, Depositor Preference, and Asset Encumbrance

IMF Working Papers, July 18, 2013

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Depositor preference and collateralization of borrowing may reduce the cost of settling the conflicts among creditors that arises in case of resolution or bankruptcy.
This net benefit, which may be capitalized into the value of the bank rather than affect creditors’ expected returns, should result in lower overall funding costs and thus a lower probability of distress despite increasing encumbrance of the bank’s balance sheet.
The benefit is maximized when resolution is initiated early enough for preferred depositors to remain fully protected.

Depositor preference and collateralization can lower conflict (bankruptcy/resolution) costs among creditors.
Lower conflict costs can be capitalized into the bank’s value rather than producing higher expected returns for creditors.
Capitalization of the net benefit leads to:
- Lower overall funding costs for the bank.
- A lower probability of distress for the bank.
Asset encumbrance (through collateralization) increases the encumbrance of the bank’s balance sheet, but the net effect can still be beneficial because of reduced resolution costs.
The timing of resolution matters: the benefit is maximized when resolution is initiated early enough for preferred depositors to remain fully protected.

Designing depositor preference regimes and collateralization rules can influence banks’ funding costs and distress probabilities via effects on resolution costs.
Ensuring that resolution is initiated sufficiently early to protect preferred depositors can maximize the stabilizing benefits of depositor preference.
Policymakers should weigh the trade-off between increased asset encumbrance and reduced creditor conflict costs when assessing bank resolution frameworks.

Source: IMF Working Paper "Bank Resolution Costs, Depositor Preference, and Asset Encumbrance" by Daniel C Hardy, July 18, 2013.