Bank resolution costs, depositor preference and asset encumbrance
Abstract
Purpose
This paper aims to clarify the effects of introducing depositor preference on resolution costs, probability of default and bank funding costs, allowing for the possibility of collateralized funding.
Design/methodology/approach
The importance of conflict among creditors in generating bankruptcy costs is documented. A model of such a conflict is provided, which is then used in analyzing the effects of depositor preference and other forms of asset encumbrance. The model takes into account the reactions of providers of secured and unsecured financing.
Findings
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.
Research limitations/implications
The interaction of asset encumbrance with liquidity risk is not addressed directly.
Practical implications
The issues addressed on the paper are currently the subject of debate by regulators and market participants. There are direct implications for prudential regulation and bank resolution policies.
Originality/value
The theory of conflict resolution is applied to bankruptcy and bank resolution, generating rigorous analysis of an important practical issue.
Keywords
Acknowledgements
© A previous version of this text was published as IMF Working Paper No. 13/172. Permission for republication has been obtained.
This paper was prepared while the author was employed at the Austrian Financial Market Authority and on leave of absence from the International Monetary Fund. The views expressed in this paper are those of the author and do not necessarily represent those of the IMF or IMF policy. Nor do they necessarily represent the views or policy of the Austrian Financial Market Authority. Patrick Darlap, Heiko Hesse, Philipp Hochreiter, Jaime Jaramillo-Vallejo, Toshi Kurosawa, Martin Larch, Luc Laeven, David Parker, Alvaro Piris Chavarri, Alexander Tieman and participants at the April 2013 International Atlantic Economic Society conference provided helpful comments.
Citation
C. Hardy, D. (2014), "Bank resolution costs, depositor preference and asset encumbrance", Journal of Financial Regulation and Compliance, Vol. 22 No. 2, pp. 96-114. https://doi.org/10.1108/JFRC-07-2013-0022
Publisher
:Emerald Group Publishing Limited
Copyright © 2014, Authors