Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
October 2, 2013
How banks fund their operations is slowly changing for the better in the wake of the crisis, although some distressed banks are still having difficulties.
People walk past a bank in Switzerland: tougher capital rules are one piece of the puzzle to make banks safer (photo: Fabrice Coffrini/Getty Images)
GLOBAL FINANCIAL STABILITY REPORT
In new research that is part of the Global Financial Stability Report, the IMF explores how global regulatory reforms will affect how banks fund themselves. The report finds that, under current conditions, the reforms will likely result in small, not drastic increases in the cost most banks incur to fund themselves.
The financial crisis showed that some types of bank funding are dangerous: short-term wholesale funding was a major culprit. When bank’s health started to look dicey, wholesale suppliers of funding decided to pull their money out of banks when their liabilities came due instead of rolling them over. It is now clearer that customer deposits (to provide a stable source of funds) and equity capital (to take losses when they occur) are necessary elements of more stable funding structures.
The crisis also made clear that taxpayers do not want their taxes used to pay for rescues of troubled banks if at all possible. So governments have been keen to revamp their practices for restructuring banks in trouble, especially those perceived as too-important-to-fail. The idea is to give bank supervisors the ability to get bank bondholders to foot some of the bill in case they need to restructure a bank, which is commonly known as a bail in.
”To accomplish this laudable goal, there should be more unsecured debt available to be ‘bailed-in’ before a government is to step into the void—that is, after shareholders lose their potential returns, some debt holders should also bear the burden of a bank’s difficulties—after all they did not purchase “risk free” debt,” said Laura Kodres, chief of the global stability analysis division in the IMF’s Monetary and Capital Markets Department that produced the report.
The IMF report said that policymakers should pay close attention to how these and other reforms interact to affect how banks fund themselves.
For instance, raising bank equity capital and building up liquidity buffers are good, and implementing over-the-counter derivatives reforms is also critical. But policymakers should allow for phase-in periods while monitoring funding conditions.
Tensions arising from reforms
Current reform efforts are designed to improve financial stability, but the IMF’s analysis reveals potential tensions among regulations designed to increase resilience to short-term liquidity shocks and proposals to facilitate bank resolutions without taxpayer support.
Resolution reforms such as “bail-in” powers, which are meant to ensure that the creditors of distressed banks suffer losses before public funds are used, and depositor preference rules that favor some depositors over other unsecured creditors in bank liquidation, have implications for bank funding structures.
The trend toward the higher use of secured funding instruments, which allocate more of the bank’s assets to these creditors in cases of default (called asset encumbrance), also has implications for funding structures.
Overall, these reforms suggest unsecured creditors will bear more risk, and as a result, the costs of unsecured debt should rise as investors require higher returns to compensate for the increased risk, notes the IMF.
While it difficult to determine how overall funding costs will develop, it appears likely that too-big-to-fail banks, which have been able to obtain funding more cheaply than other banks, will see their costs rise as their implicit government subsidy is lessened, the IMF said.
Additionally, some banks may find it difficult to issue senior unsecured debt if the riskiness of this debt rises enough that their typical investor base—such as pension funds and insurance companies—are not allowed to hold it. These banks may be unable to maintain sufficient loss-absorbing liabilities to meet the reforms’ objectives.
The IMF analysis capturing these potential tradeoffs shows that the price impact on unsecured senior debt spreads is expected to be relatively small under current conditions, including in euro area countries. However, the results depend importantly on the share of preferred deposits and liabilities exempted from being bailed-in and so monitoring these elements to ensure there is enough unsecured debt available to be bailed-in will be important.
Since increasing banks’ equity capital reduces the cost of any types of debt, capital regulations should continue to be a mainstay of the reform efforts. Basel III liquidity and over-the-counter (OTC) derivative reforms should also be implemented as planned. However, policymakers may want to set limits on asset encumbrance or require a minimum proportion of bail-in debt relative to assets. This way a sufficiently large proportion of unsecured debt is preserved to absorb losses when bank capital is exhausted, providing an important protection against the future use of taxpayer funds.
