A Theory of Bank Resolution: Political Economics and

Technological Change

Robert DeYoung (University of Kansas)and Jack Reidhill (FDIC)

Comments by Phil Molyneux (Bangor University)

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Aim of Paper

Presents a novel theoretical framework to explain the features of bank resolution

Focuses on the trade-off between LIQUIDITY and MARKET DISCIPLINE

Explains how new resolution technologies + other institutional / economic features interplay to alter liquidity and market discipline trade-offs

Also emphasises how depositor + borrower liquidity are associated with different resolution approaches + are correlated

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The Model

One period framework Exogenous bank insolvency One authority with responsibility for resolution Resolution strategy assumed to provide a

combination of liquidity and market discipline that maximizes the resolution authorities welfare (not necessarily the same as social welfare)

Resolution constrained by technological factors + governmental factors (both broadly defined)

Graphical exposition

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The Model – Liquidity versus Discipline

0% MD 100%

100%

0%

LQ

Figure 1OBA

AL

DP

TTINEFF

OBA (Open Bank Assistance): 100% Liquidity Support, No MD, RA provides cash, owners keep control.

DP (Depositor Payout): Purchase and Resumption , RA takes over, pays insured depositors quickly (if not then T shifts to left reducing utility)

AL (Asset Liquidation): RA takes over, pays depositors from asset sales.

Social Optimum

ResolutionTechnology (T)Discontinous

Shape of Indifferencecurves reflect preference for liquidity over discipline

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The Model – Liquidity versus Discipline – Other Scenarios Figure 2 – Resolution technology improves, shifts T

to right, improves welfare (for RA) Figure 3 – New resolution technology (Bridge bank)

improves utility for RA that favours liquidity over market discipline (although relative to DP moral hazard incentives have increased)

Figure 4 – Big bank failures – imposing discipline – liquidity price of discipline increases. T pivots to left

Figure 5 – Government constraints on liquidity support for big bank failures, T pivots to left, liquidity constraint – RA utility lower than other outcomes but social welfare still greater than full bailout

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Contribution

Provides a novel and illuminating theoretical insight into the trade-off between market discipline and liquidity provision in the case of bank resolution

Linked neatly to the evolution of FDIC resolution practices from 1933-1992, with interesting cases of various US bank bailouts (in Annex)

Raises questions about bank resolution practices elsewhere

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Some Questions

The model assumes a trade-off between protecting liquidity and market discipline: If the resolution technology is discontinous (maybe step-

like) + if it is bank failure specific then utility improvements perhaps can only be gauged on case-by-case basis

Is there evidence that market discipline is economically important? Theorists seem to think so but the empirical evidence on equity, sub debt and uninsured depositors is not massively strong (especially outside the US). If regulation does not provide some degree of market discipline pre-failure why would one expect it to have a big influence via the resolution process? Maybe your indifference curves + T should be much steeper?

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Some Questions Who remembers Capital? Basel 2 – reducing all banks regulatory

capital?? Is there any sort of trade-off between liquidity and capital in the

resolution process? What is (+ has there been) a trade-off between the two over

recent years? US banks have traditionally held relatively low on-balance sheet

liquid assets + high capital compared to their European counterparts (although the latter’s liquid assets have fallen substantially post Basel 1).

Maybe market discipline issues, pre and post resolution, are linked to capital / liquidity relationships

Possibly you could feed capital into your modelling framework as a third dimension? Capital probably needs some mention before we arrive at Basel Liquidity 1????