October 2010
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Mario Draghi (Head of the FSB)
Financial Times, 9/16/2010
Slide 2

Two main approaches to reform:
1.
More capital / regulation: “make failure impossible”
2.
Create a viable bank resolution process: “make failure manageable”
Some key questions:
–
Can we make failure impossible?
–
What is critical to reduce risk of contagion / systemic collapse?
– Is the goal “strict justice” or an “economic efficiency”?
–
Should governments supply risk capital (or protect certain investors)?
–
Can we address moral hazard?
–
How to deal with the international dimension?
–
How will participants react to the solution? Is the solution stable?
Slide 3

Bankruptcy – liquidate assets and distribute proceeds
Bail-out – use tax dollars / guarantees to protect [some] investors
Dodd-Frank – FDIC seizure + “orderly liquidation process”
Narrow Banking / Atomized Banking – “small enough to fail”?
Resolution Fund
– create a pool to “socialize” loss
Co-Cos / BCBS 174 – helpful . . . but enough to turn the tide?
 Bail-in – fast track recapitalization + supporting measures
Slide 4

1) Write-down assets (~ $25 bn rough estimate)
2) Recapitalize : Old Balance Sheet New Balance Sheet
$25bn equity  warrants
$25bn preferred & sub debt  new equity
$120bn senior debt  15% equity (85% unchanged)
No impact on customers, repo, swaps or insured deposits
3) Top Management is removed
4) Liquidity plan established
 “New Lehman”- best capitalized bank in the US
Investor losses:

Bail-in: ~ $25bn vs.

Liquidation : ~ $150bn
(current market value)
–
Customer activities continue as normal – going concern
–
No government capital at risk – not a bail-out
–
System under much less stress
Slide 5

1) Write-down: Best estimate - credible to market, and fast (not perfect)
2) Recapitalize: restore capital (post-write-down) to a very strong position
–
Haircut / convert unsecured capital (starting with equity up to senior unsecured debt, as needed to create sufficient equity, in order of creditor priority)
– No haircuts to “customer activities” (e.g. transaction payments, settlements, prime banking, normal derivatives – activities that are crucial for a banking franchise)
–
No haircuts to protected liability classes (normal repo, insured deposits)
–
Protocol of how investors are treated in recap should have clear terms – not
“constructive ambiguity”. Should include: strict priority; fairness within each class and across borders; and transparency (so investors can make good decisions)
3) Management: remove CEO, maybe others - but need to keep some key leaders
4) Liquidity: need a clear, convincing plan (e.g. consortium funding “LTCM” model, possibly central bank support). Supersenior “DIP” financing could be a key tool
Slide 6

Best legal foundation is likely a hybrid, using both statutory & contractual elements

Confer key powers and responsibilities on home regulator

Augment with contractual support (e.g. debt issued outside home country)
 Over time, could be supported by mutual recognition and other agreements
 Allows for a “building block” approach, which could be adopted nation by nation, rather than requiring a difficult initial multi-lateral agreement.
Legal process must be convincing & quick (e.g. a weekend) to ensure confidence.
 Process could allow for some ex post rebalancing of claims among classes, but overall recapitalization must be convincing to the market.
 Living Wills could be an extremely helpful preparatory tool
– to ensure speed and efficacy
Trigger for bail-in should be very late “non-viability” finding by lead regulator

Equivalent to regulatory seizure
– other normal private options exhausted

Must precede legal bankruptcy to avoid acceleration of contracts /debt.

Swap acceleration must be avoided; ISDA protocol process likely best route
International
„ring-fencing“ must be avoided to keep franchise alive

Bail-in can provide strong incentives for cooperation, even in crisis. It creates capital and liquidity
– the 2 elements that a stressed host regulator needs most
Slide 7

Political/ regulatory:
We called upon the FSB to . . develop concrete policy to . . resolve systemically important financial institutions by the Seoul
Summit. This should include . . contingent capital, bail-in options . .
(Toronto G20 Communiqué)
Effective regimes . . should include powers that facilitate “going concern” capital and liability restructuring. . .
Statutory powers enabling the resolution authority to bail-in senior debt holders would expand the options for going concern resolution . .
(Mario Draghi, Head of FSB)
Credit Research:
JP Morgan, CreditSights,
Barclays
Bank Associations:
Recent Press
“probably the best idea out there right now”
(Financial Times, July)
“The bail-in idea deserves a strong push”
(Breaking Views / NY Times, September
“a particularly intriguing idea kicking around Basel is the concept of a "bail-in"
(Wall St Journal Editorial, September)
Slide 8


Avoid government-backed bail-outs
–
Creates access to huge pool of potential equity in a crisis (2x – 5x larger)
–
Extra capital cushion can absorb losses much greater than 2008 crisis
– Effectively forms a deep “resolution fund” funded by private capital

Major reduction in systemic risk
–
Dramatically reduces cost of bank failure and contagion
–
Protects depositors, and key customer activities – should reduce runs
–
Could help solve the vexing problem of cross border resolution

Better for the real economy - and likely a more durable reform
–
A more efficient, market-oriented alternative
–
Better market signals will help discipline management & inform regulators
Slide 9