The Economics of Bank Restructuring: Understanding the Options
40 Pages Posted: 5 Jun 2009
Date Written: June 5, 2009
Based on a simple framework, this note clarifies the economics behind bank restructuring and evaluates various restructuring options for systemically important banks. The note assumes that the government aims to reduce the probability of a bank's default and keep the burden on taxpayers at a minimum. The note also acknowledges that the design of any restructuring needs to take into consideration the payoffs and incentives for the various key stakeholders (i.e., shareholders, debt holders, and government). If debt contracts can be renegotiated easily, the probability of default can be reduced without any government involvement by a debt-for-equity swap. Such a swap, if appropriately designed, would not make equity holders or debt holders worse off. However, such restructurings are hard to pull off in practice because of the difficulty of coordinating among many stakeholders, the need for speed, and the concerns of the potential systemic impact of rewriting debt contracts. When debt contracts cannot be changed, transfers from the taxpayer are necessary. Debt holders benefit from a lower default probability. Absent government transfers, their gains imply a decrease in equity value. Shareholders will therefore oppose the restructuring unless they receive transfers from taxpayers. The required transfer amounts vary across restructuring plans. Asset sales are more costly for taxpayers than asset guarantees or recapitalizations. This is because sales are not specifically targeted to reduce the probability of default. Guarantees or recapitalizations affect default risk more directly. Transfers can also be reduced if the proceeds of new issues are used to buy back debt. Depending on the options chosen, restructuring may generate economic gains. These gains should be maximized. Separating out bad assets can help managers focus on typical bank management issues and thereby increases productivity. Because government often lacks the necessary expertise to run a bank or manage assets, it should utilize private sector expertise. Low up-front transfers can help prevent misuse of taxpayer money. Moreover, the design of bank managers' compensation should provide incentives to maximize future profits. If participation is voluntary, a restructuring plan needs to appeal to banks. Bank managers often know the quality of their assets better than the market does. This means banks looking for new financing will be perceived by the market to have more toxic assets and, as a result, face higher financing costs. Banks will therefore be reluctant to participate in a restructuring plan and demand more taxpayer transfers. A restructuring that uses hybrid instruments - such as convertible bonds or preferred shares - mitigates this problem because it does not signal that the bank is in a dire situation. In addition, asset guarantees that are well designed can be more advantageous to taxpayers than equity recapitalizations. A compulsory program, if feasible, would obviously eliminate any signaling concerns. Information problems can also be mitigated if the government gathers and publicizes accurate information on banks' assets. In summary, systemic bank restructuring should combine several elements to address multiple concerns and trade-offs on a case-by-case basis. In any plan, the costs to taxpayers and the final beneficiaries of the subsidies should be transparent. To forestall future financial crises, managers and shareholders should be held accountable and face punitive consequences. In the long run, various frictions should be reduced to make systemic bank restructuring quicker, less complex, and less costly.
Keywords: Bank Restructuring, Recapitalization, Asset Sales, Cost of Financial Distress
JEL Classification: G21, G28, G33, H21
Suggested Citation: Suggested Citation